Just part B

Question 2 (Public Spending in the one-period model)

Suppose you are the economic advisor of a fictitious president who lives in a world with only one time period. Consumers and firms in this economy are similar to the consumers and firms studied in weeks 2 and 3. Assume that the substitution effect is stronger than the income effect. The government can only collect revenue through lump-sum taxes. Suppose you are in a meeting and the president tells you the following

"I am worried about my re-election prospects; I will increase public spending to construct roadways. What do you think?"

At first, you believe that this public spending is unproductive, then you quickly pick up pencil and paper to

a) Show the president that an increase in unproductive government spending makes consumers worse off.

After your brilliant explanation, the president says:

"Why are you assuming this spending is unproductive? We will construct roadways, which increase the stock of capital firms use to produce."

b) Show the president that an increase in productive government spending that increases the stock of capital has ambiguous effects on the welfare of consumers

Finally, the president says:

"Why do you keep talking about welfare? Welfare does not make the headlines. We need increases in GDP."

Rubric: Draw the appropriate graph to show the effect twice.Label the axes, name the curves, and identify the optimal consumption bundle. Show how the increase in productive government spending changes the graph. First, draw the case in which consumers are worse off after the change (3 points). Explain with words why (2 points). In the second graph, draw the case in which consumers are better off (3 points). Explain with words why (2 points).