Increasing returns, capital utilization, and the effects of government spending

We show that a one-sector real business cycle model with mild increasing returns-to-scale, variable capital utilization and saddle-path stability is able to produce qualitatively realistic business cycles driven solely by disturbances to government purchases. Due to an endogenous increase in labor productivity, a positive spending shock can lead to simultaneous increases in output, consumption, investment, employment and real wage. Our analysis illustrates a close relationship between this result and the recent literature that explores indeterminacy and sunspots in real business cycle models under laissez-faire. In particular, the condition which governs the required magnitude of increasing returns for government spending shocks to generate procyclical macroeconomic e+ects is identical to that necessary for a laissez-faire one-sector real business cycle model to exhibit local indeterminacy. ? 2003 Elsevier B.V. All rights reserved. JEL classi&cation: E30; E32; E62