A New Keynesian model characterized by labor indivisibilities, unemployment and a unionized labor market is presented. The bargaining process between unions and firms introduces real wage rigidity and creates an endogenous trade-off between inflation and output stabilization. Under an optimal discretionary monetary policy a negative productivity shock requires an increase in the nominal interest rate. An operational instrument rule will satisfy the Taylor principle, but will also require that the nominal interest rate does not necessarily respond one to one to an increase in the efficient rate of interest.