Suppose that the production function that the rm operates is now given by

Y = z(G)F(K;N^d); with z(G) = ( z bar + aG);

where z > 0, a > 0, and G > 0 is government spending.

Notice that in this framework government spending makes firms more productive (for example, government expenditures on roads and bridges lowers the cost of transportation).

The budget constraint for the government is G = T, where T are lump-sum taxes.

1. Suppose that the government decides to increase G. Using a diagram, determine the equilibrium e acts of this shock on aggregate output, consumption, employment, and the real wage. Show that increasing G can potentially increase welfare.

2. Compare your results with the case of unproductive government spending studied in class (i.e., when a = 0).