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In a two-sector model, where one of the sectors is monopolistically competitive and subject to increasing returns to scale but without love for variety, the author analyzes the effects of a balanced budget fiscal expansion. Such an expansion could increase the welfare of the representative individual, if elasticities of substitution in production and consumption are low. A reorganization of production takes place - increasing returns enabling a rise in real income. The author has shown that in a monopolistically competitive economy with increasing returns to scale, welfare rises following a balanced-budget fiscal expansion. The assumed low elasticities of substitution in production and consumption require large changes in prices to equilibrate markets following a shock.
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