Monopolistic Competition, Increasing Returns, and the Effects of Government Spending

By Devereux, Michael B.; Head, Allen C. et al. | Journal of Money, Credit & Banking, May 1996 | Go to article overview

Monopolistic Competition, Increasing Returns, and the Effects of Government Spending


Devereux, Michael B., Head, Allen C., Lapham, Beverly J., Journal of Money, Credit & Banking


In the last decade, a large literature has explored the effects of government spending in dynamic general equilibrium environments. papers in this area are based on the one-sector neoclassical growth model with constant returns to scale. For example, Aiyagari, Christiano, and Eichenbaum and Baxter and King (1993) explore the responses of economic aggregates to temporary and permanent changes in government spending in this model, extending the earlier work of Barro (1981, 1989) and Hall (1980). In these studies, the effects of government spending stem mainly from its negative wealth effects. In response to a temporary increase in government spending, employment and output rise while both real wages and consumption fall. In addition, as Barro and King (1984) show, in a model with constant returns and time separable utility, government spending shocks generate a negative relationship between consumption and hours worked. These findings have been seen as difficult to reconcile with observed co-movements in aggregate variables. For example, it has been recognized since Dunlop (1930) and Tarshis (1939) that the negative relationship between real wages and employment is not present in the data. Also, it is a well-documented observation that consumption and employment move together over the business cycle.

This paper explores the effects of government spending in a model with increasing returns and monopolistic competition. We find that changes in government spending may have markedly different effects in this economy than in the neoclassical model with constant returns. Our findings stem mainly from the fact that in our economy an increase in the level of government spending results in an endogenous increase in total factor productivity in spite of the fact that the spending itself is entirely wasteful. If this increase in productivity is great enough, a government spending shock may result in simultaneous increases in output, employment. wages, and consumption. Motivation for a link between government spending and total factor productivity in the United States has been provided by Evans (1992) and Hall (1990). Both of these studies have found that a standard measure of total factor productivity, the Solow residual, is not invariant to changes in the level of government spending. Similar results have been found for France and the United Kingdom by Ravn (1992).

In our model monopolistically competitive firms supply intermediate goods under conditions of free entry. Intermediate goods are used to produce a single final good. The productivity of any one intermediate good depends positively on the total number of intermediates in use. This specification reflects a type of "increasing returns to specialization" commonly used in international trade theory and endogenous growth theory. In the presence of returns to specialization, fluctuations in government demand for the final good generate movements in total factor productivity by changing the equilibrium number of firms operating in the intermediate goods industry. This is a simple way of capturing the spirit of a "thick market" effect as described by Diamond (1982) and Hall (1992). In the model, periods of high output coincide with entry of new firms and high productivity, whereas when output is low, firms exit, and productivity is low. In addition, the procyclical behavior of net entry of new firms is a noted business cycle feature in the U.S. economy (for example, Audretsch and 1992 and Chatterjee, Cooper, and Ravikumar 1993). Davis and Haltiwangar (1990) also show that firm entry and exit have significant impact on labor fluctuations. For the period 1972-86 they estimate that annually 25 percent of gross job destruction and 20 percent of gross job creation in U. S. manufacturing can be attributed to establishment deaths and births, respectively.

We consider the effects of both permanent (steady-state) changes in the share of government spending in aggregate output and temporary shocks to the level of government spending in a neighborhood of the steady state. …

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Monopolistic Competition, Increasing Returns, and the Effects of Government Spending
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