Econ 208

Marek KapickaLecture 6

The Effects of Gov’t Spending

B2) The Effects of Government Spending Extension#2: Monopolistic Competition

Suppose that instead of competitive markets, there is monopolistic competition There is a final good producer that

demands the intermediate goods There are many small identical,

monopolistic firms producing intermediate goods

where is markup

𝑉 ′ (𝐻𝑡)𝑈 ′ ¿¿

B2) The Effects of Government Spending Extension#2: Monopolistic Competition

Since is constant, the frictionless economy with monopolistic producers behaves similarly as the competitive economy The fiscal multiplier is exactly the same

Note that the level of production is inefficiently low

B2) The Effects of Government Spending Frictions

Larger increase in would be possible if rises more than

Introduces a ‘’labor wedge’’ into the equilibrium condition:

Before we had . If then the fiscal multiplier is larger

B1) The Effects of Government Spending Equilibrium Conditions

𝑉 ′ ( 𝑓 −1(𝑌 𝑡))𝑈 ′(𝑌 𝑡−𝐺𝑡)𝑓 ′ ¿

𝑌 𝑡𝑌 𝑡∗

𝑤𝑡

B2) The Effects of Government Spending Frictions

How to justify increasing ? Assume sticky prices: some producers cannot change their nominal price

How much the labor wedge changes depends on How sticky prices are What the monetary policy does

B2) The Effects of Government Spending Frictions

Suppose that there is a nominal price of the final good . Each producer charges a nominal price for its product Before we had and, in equilibrium, .

Suppose that a fraction cannot change the output price (fixed producers)

The remaining fraction can choose prices freely (flexible producers)

B2) The Effects of Government Spending Frictions

Final good producer has a CES production function

Intermediate good producers:

𝑌 𝑡=[∫01

𝑦𝑡 (𝑖 )𝜃−1𝜃 𝑑𝑖 ]

𝜃𝜃 −1

𝑦 𝑡(𝑖)=h𝑡 (𝑖 )𝛼

B2) The Effects of Government Spending Frictions

Suppose that before an increase in government spending there is A fraction of firms has to keep

Think of monetary policy controlling directly

can be correlated with

B2) The Effects of Government Spending Frictions

Final good producer

Intermediate good producers:

𝑌 𝑡=[∫01

𝑦𝑡 (𝑖 )𝜃−1𝜃 𝑑𝑖 ]

𝜃𝜃 −1

𝑦 𝑡 (𝑖 )=h𝑡 (𝑖 )𝛼 𝑖∈ [0,1 ]

B2) The Effects of Government Spending Frictions

Final good producer demands:

Fixed intermediate good producers:

Flexible intermediate good producers

𝑦 𝑡 (𝑖 )=𝑌 𝑡 (𝑞𝑡 (𝑖 )𝑃 𝑡

)−𝜃

𝑦 𝑡 (𝑖 )=𝑌 𝑡𝑃 𝑡𝜃 𝑖∈[0 ,𝛾 ]

𝑤𝑡=𝜃−1𝜃 𝑌 𝑡

❑1𝜃𝛼 𝑦 𝑡

❑ (𝑖 )𝛼− 1𝛼 − 1𝜃 𝑖∈ [𝛾 ,1]

B2) The Effects of Government Spending Frictions

In equilibrium, obtain

Corresponds to If an increase in triggers an increase

in the price level then increases with A response of monetary policy

matters!

𝑤𝑡=𝜃−1𝜃 [ 1−𝛾

1−𝛾 𝑃 𝑡𝜃 −1 ]

11−𝜃𝛼𝑌 𝑡

❑𝛼−1𝛼

Δ= 𝜃𝜃−1 [ 1−𝛾

1−𝛾 𝑃 𝑡𝜃−1 ]

1𝜃 −1

Results from a world with frictions If prices are sticky and the monetary

policy reacts to increased government spending by producing some inflation, the fiscal multiplier is larger

If monetary policy maintains constant price level then the fiscal multiplier is the same as before

Empirical Evidence Main question:

How does consumption and wages respond to an increase in government spending?

Valerie Ramey (2008): The effects of military expenditures

Largely unrelated to other economic factors

Real Government Spending Per Capita

The effects on GDP

The Effects on Consumption and Wages