Fiscal Policy, Distortionary Taxation and Direct Crowding Out Under Monopolistic Competition

A simple macroeconomic model with monopolistic competition on the goods market is developed which displays Keynesian features. The model is used to study the effects of a rise in public spending on national income. The model extends the literature in two directions. First, we assume that the government balances its budget by employing distortionary income taxation. Second, we allow for direct crowding out since public consumption enters private utility in a non-separable fashion. It is shown that an increase in public spending depresses national income, particularly if there is not much crowding out and firms have a lot of market power. We also derive that the short-run national income multiplier (with a fixed number of firms) exceeds the long-run multiplier (with free entry and exit of firms). The marginal cost of public funds is unambiguously smaller in the short run than in the long run, which implies a larger government sector in the short run