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Do real balance effects invalidate the Taylor principle in closed and open economies?

  • Stephen McKnight


    (El Colegio de México)

  • Alexander Mihailov


    (University of Reading)

This paper examines the implications for equilibrium determinacy of forward-looking monetary policy rules in a Neo-Wicksellian model that incorporates real balance effects. We show that in closed economies the presence of small, empirically plausible real balance effects significantly restricts the ability of the Taylor principle to prevent indeterminacy of the rational expectations equilibrium. This problem is further exac- erbated in open economies, particulary if the monetary policy rule reacts to consumer- price, rather than domestic-price, inflation. These findings still hold even when output and the real exchange rate are introduced into the policy rule, thereby suggesting that the widespread neglect of real balance effects in the literature is ill-advised.

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Paper provided by El Colegio de México, Centro de Estudios Económicos in its series Serie documentos de trabajo del Centro de Estudios Económicos with number 2012-10.

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Date of creation: May 2012
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Handle: RePEc:emx:ceedoc:2012-10
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