Government Spending and Welfare with Returns to Specialization  Michael B. Devereux University of British Columbia, Vancouver, BC V6T 1Z1, Canada Allen C. Head and Beverly J. Lapham Queen's University, Kingston, ONT K7L 3N6, Canada Abstract We explore a novel channel through which government spending can stimulate consumption and welfare through its effects on aggregate productivity, without directly affecting either utility or production possibilities. In the presence of monopolistic competition and increasing returns to specialization, it is shown that government spending can partly alleviate the inef®ciencies of monopolistic competition. This is because government spending generates an endogenous increase in total factor productivity by increasing the variety of intermediate goods. If the degree of increasing returns to variety is large enough, a rise in such wasteful government spending may increase consumption levels enough to increase welfare. Keywords: Increasing returns to scale; government spending JEL classi®cation: E60 I. Introduction It is well known that in the standard neoclassical growth model, increases in government spending tend to increase economic activity by stimulating labor supply; see, for example, Aiyagari, Christiano, and Eichenbaum (1992). Since increased employment can only occur if there is a fall in the real wage, aggregate consumption must fall, and thus welfare is reduced (unless gov- ernment spending is a perfect substitute for private consumption). We demonstrate that in the presence of a market inef®ciency due to monopolistic competition and increasing returns, government spending may be welfare improving, regardless of whether the spending is put to any useful purpose. Moreover, government spending stimulates productivity and welfare purely through its effect on overall economic activity, without directly affecting utility or production possibilities. We illustrate this in a simple, analytically tractable, version of the neoclassical growth model. Scand. J. of Economics 102(4), 547±561, 2000 # The editors of the Scandinavian Journal of Economics 2000. Published by Blackwell Publishers, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA.  We thank two anonymous referees for very insightful comments. We alsogratefully acknow- ledge ®nancial support from the Social Science and Humanities Research Council of Canada.