Real balance effects, determinacy and optimal monetary policy

This paper presents a dynamic New Keynesian macroeconomic model with real balance effects. Both the conditions of equilibrium determinacy under an interest rate rule of the Taylor-type and the implications for optimal monetary policy are considered. We find a number of results that would not appear in the traditional frame-work. It is shown that the real balance effect makes the so-called “Taylor principle ” not necessary for determinacy of rational expecta-tions equilibrium. A relatively “passive ” monetary policy is found to be feasible also in the long run, but not necessarily optimal. In partic-ular, within a class of policy rules constrained to be a linear function of state variables, an “active ” optimal interest rate rule is more likely to be verified under commitment rather than under discretion