Question

Suppose that government spending makes private irms more productive; for example, government spending on roads and bridges lowers the cost of transportation. This means that there are now two efects of government spending, the irst being the efects discussed in this chapter of an increase in G and the second being similar to the efects of an increase in the nation’s capital stock K. (a) Show that an increase in government spending that is productive in this fashion could increase welfare for the representative consumer. (b) Show that the equilibrium efects on consumption and hours worked for an increase in government spending of this type are ambiguous but that output increases. You must consider income and substitution efects to show this

Answer 1

b) Output of the economy will increase as the lower cost of production will push firms to produce more, hence increasing the to tal outpot of the economy. Now the effect on consumption and hours worked can move in both the direction due to income and substitution effect depending upon the factor that which effect is stronger, As price will go down, people will have a feeling as if their incomes hasve increased so due to income effect they will move towards leisure and will want to work less but subtitution effect will work in opposite direction as people will need to work more to but more leisure. Consumption may increase or decrease because government spending will lower the prices on both normal & inferior goods. So its direction actually depends upon the goods basket of the consumers