Real Balance Effects and Monetary Policy

This article presents a dynamic stochastic new Keynesian model with real balance effects. I find a number of results that would not appear in the traditional framework. It is shown that the real balance effect makes the so‐called Taylor principle not necessary for determinacy of rational expectations equilibrium and that “passive” monetary rules may be feasible. In addition, within a class of policy rules constrained to be a linear function of state variables, “active” interest rate rules are more likely to be optimal under commitment rather than under discretion. (JEL E52 , E58 )