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Do Real Balance Effects Invalidate the Taylor Principle in Closed and Open Economies?

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  • Stephen McKnight
  • Alexander Mihailov

Abstract

type="main" xml:id="ecca12134-abs-0001"> This paper examines the determinacy implications of forecast-based monetary policy rules that set the interest rate in response to expected future inflation in a Neo-Wicksellian model that incorporates real balance effects. We show that the presence of such effects in closed economies restricts the ability of the Taylor principle to prevent indeterminacy of the rational expectations equilibrium. The problem is exacerbated in open economies, particularly if the policy rule reacts to consumer-price, rather than domestic-price, inflation. However, determinacy can be restored in both closed and open economies with the addition of monetary policy inertia.

Suggested Citation

  • Stephen McKnight & Alexander Mihailov, 2015. "Do Real Balance Effects Invalidate the Taylor Principle in Closed and Open Economies?," Economica, London School of Economics and Political Science, vol. 82(328), pages 938-975, October.
    • Handle: RePEc:bla:econom:v:82:y:2015:i:328:p:938-975
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    File URL: http://hdl.handle.net/10.1111/ecca.2015.82.issue-328
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    Cited by:

    1. Gurrola Luna, Alejandro & McKnight, Stephen, 2026. "Bounded rationality and macroeconomic (in)stability," Economic Modelling, Elsevier, vol. 155(C).
    2. McKnight, Stephen & Mihailov, Alexander & Pompa Rangel, Antonio, 2020. "What do Latin American inflation targeters care about? A comparative Bayesian estimation of central bank preferences," Journal of Macroeconomics, Elsevier, vol. 63(C).
    3. Ida, Daisuke, 2023. "The effect of real money balances on international monetary policy transmission," Journal of International Money and Finance, Elsevier, vol. 139(C).
    4. McKnight, Stephen, 2018. "Investment And Forward-Looking Monetary Policy: A Wicksellian Solution To The Problem Of Indeterminacy," Macroeconomic Dynamics, Cambridge University Press, vol. 22(5), pages 1345-1369, July.
    5. Levine, Paul & McKnight, Stephen & Mihailov, Alexander & Swarbrick, Jonathan, 2025. "Limited asset market participation and monetary policy in a small open economy," Journal of Economic Dynamics and Control, Elsevier, vol. 173(C).
    6. Ida, Daisuke, 2025. "The neo-Fisherian effect in a new Keynesian model with real money balances," The North American Journal of Economics and Finance, Elsevier, vol. 80(C).
    7. Vadim O. Grishchenko & Alexander Mihailov & Vasily N. Tkachev, 2021. "Money Creation in Russia: Does the Money Multiplier Exist?," Economics Discussion Papers em-dp2021-15, Department of Economics, University of Reading.
    8. McKnight, Stephen & Mihailov, Alexander & Rumler, Fabio, 2020. "Inflation forecasting using the New Keynesian Phillips Curve with a time-varying trend," Economic Modelling, Elsevier, vol. 87(C), pages 383-393.

    More about this item

    JEL classification:

    • E41 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Demand for Money
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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