RBC Model with Productive Public Spending
(a)Suppose that the government introduces a fiscal stimulus package by increasing current government spending G. Which are the effects of this fiscal stimulus on the real wage, employment, the real interest rate, and output? Explain by using the equilibrium diagrams for the current labour market and for the current goods market.
(b) Would the fiscal multiplier be larger under productive or under unproductive government spending? Justify your answer carefully.
Extracted text: In the standard Real Business Cycle (RBC) model, it is assumed that government spending (either in the first or in the second period) is unproductive. In this problem you will analyse the implications of modifying that assumption. In particular, consider the RBC model studied in class with the following modification: suppose that in the first period the representative firm produces output Y by operating the following technology: Y = z(G)F(K, N“). where K denotes physical capital in the first period, Nd is labour demanded in the first period, and z(G) is total factor productivity (TFP) in the first period, given the level of public spending in the first period G. Importantly, z'(G) > 0, so that TFP is increasing in G. In this sense, government spending in the first period is productive (this would capture, for example, the effect of better public roads on the firm's productivity). Except for this feature, the model is identical to the RBC model studied in class. Using this modified version of the RBC model, answer the following questions. Assume throughout that the economy is closed (i.e., it does not trade with the rest of the world).