Government Spending and Welfare with Returns to Specialization

We explore a novel channel through which government spending can stimulate consumption and welfare through its effects on aggregate productivity, without directly affecting either utility or production possibilities. In the presence of monopolistic competition and increasing returns to specialization, it is shown that government spending can partly alleviate the inefficiencies of monopolistic competition. This is because government spending generates an endogenous increase in total factor productivity by increasing the variety of intermediate goods. If the degree of increasing returns to variety is large enough, a rise in such wasteful government spending may increase consumption levels enough to increase welfare.
JEL classification : E 60