Are New Keynesian Models Useful When Trend Inflation is Not Low?

Sergio Lago Alves and Hashmat Khan
Additional contact information
Sergio Lago Alves: Central Bank of Brazil
Hashmat Khan: Carleton University

No 24-08, Working Papers from Chair in macroeconomics and forecasting, University of Quebec in Montreal's School of Management

Abstract: The equilibrium in the standard New Keynesian (NK) model with Calvo-pricing becomes explosive at low levels of trend inflation (between 4 to 7 percent). Even halfway before that threshold, optimal prices, price dispersion and costs rise fast to very large levels, and output plummets. We show that the root of these issues is not Calvo pricing as commonly assumed, but rather the popular Dixit-Stiglitz demand structure in NK models. Considering models with general firms' demand functions, we provide two important results: (i) regardless of the price setting behavior, i.e. timeor state-dependent, marginal costs rapidly increasing with trend inflation is a direct consequence of demand functions that fast rise at low relative prices; and (ii) under Calvo pricing, the condition for NK models to always have a stable equilibrium, independently of the level of trend inflation, is that the demand function does not increase unboundedly as relative prices decrease. The Dixit-Stiglitz demand structure fails to satisfy the latter condition. We then propose a model with price wedges to augment any existing demand structure and make them in line with those conditions. Using Dixit-Stiglitz and Kimball-demand aggregators, we show that the generalized NK model with price wedges allows price dispersion to rise slowly with trend inflation and avoids output plummeting to zero. In addition, the implied demand function with price wedges has relatively superior properties, better aligned with the micro and macro evidence.

Keywords: New Keynesian models; Calvo pricing; trend inflation; steady state problem; demand functions (search for similar items in EconPapers)
JEL-codes: E31 E32 E52 (search for similar items in EconPapers)
Pages: 54 pages
Date: 2024-08, Revised 2024-08
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
https://chairemacro.esg.uqam.ca/wp-content/uploads/sites/146/f204503.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:bbh:wpaper:24-08

Access Statistics for this paper

More papers in Working Papers from Chair in macroeconomics and forecasting, University of Quebec in Montreal's School of Management Contact information at EDIRC.
Bibliographic data for series maintained by Dalibor Stevanovic and Alain Guay ().