Government spending and welfare with returns to specialization

We explore a novel channel through which government spending can stimulate consumption and welfare through its effects on aggregate productivity, with out directly affecting either utility or production possibilities. In the p resence of monopolistic competition and increasing returns to specializatio n, it is shown that government spending can partly alleviate the inefficien cies of monopolistic competition. This is because government spending gener ates an endogenous increase in total factor productivity by increasing the variety of intermediate goods. If the degree of increasing returns to varie ty is large enough, a rise in such wasteful government spending may increas e consumption levels enough to increase welfare.