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

The equilibrium in the standard New Keynesian (NK) model with Calvo pricing becomes explosive at low levels of trend inflation (4 to 7 percent). Even halfway before this threshold, optimal prices, price dispersion, and costs rise rapidly to large values, while output plummets. We show that these well-known issues stem not from Calvo pricing itself but from its interaction with the widely used Dixit-Stiglitz demand structure in NK models. Using a framework with general firms’ demand functions and Calvo pricing, we demonstrate that for NK models to have a stable equilibrium at any level of trend inflation, the demand function must not increase unboundedly as relative prices decrease — a condition the Dixit-Stiglitz structure fails to meet. We propose a model with price wedges to modify existing demand structures to satisfy this condition. Applying this approach to models with Dixit-Stiglitz and Kimball-demand aggregators, we show that the generalized NK model with price wedges stabilizes price dispersion under rising trend inflation and prevents output from collapsing. Moreover, this model exhibits superior theoretical and empirical properties, aligning better with micro and macro evidence. It also introduces new implications for the slope of the Phillips curve and the effects of monetary shocks.