Government spending and monopolistic competition with heterogeneous firm productivity

This paper builds up a monopolistically competitive macroeconomic model featuring firm heterogeneity in productivity. In addition to firm heterogeneity in productivity, this paper also brings the congestion effect due to competitive differentiation and the culture of the leisure externality into the analysis. The main purpose of this study is to examine how these three factors affect the linkage between the economy’s average productivity level and fiscal spending as well as the possibility of a fiscal crowding-in effect on private consumption. Several main findings emerge from the analysis. First, in the presence of the congestion effect, the average productivity level will increase in response following an expansion in fiscal spending. Second, the greater the congestion externality, leisure externality and firm productivity heterogeneity, the greater the tendency for the emergence of the fiscal crowding-in effect on private consumption to increase. Third, a fiscal expansion may improve social welfare, provided that the congestion effect, the extent of preferred leisure externalities, and the extent of firm productivity heterogeneity are sufficiently high.