Many people believe that Congress will eventually have to reduce Social Security

Question

Many people believe that Congress will eventually have to reduce Social Security benefits in order to reduce the budget deficit. Although most of the changes would not take place until later, assume for the purpose of this problem that Social Security benefits were cut today by $100billion per year.
A) If the marginal propensity to consume is 0.8, explain what the long-run effects would be on real GDP, public saving, and national saving.
B) The US is a large open economy with a trade deficit. Use the appropriate graphs to illustrate and state what the reduction in Social Security benefits would do to each of the following inthe long run: national saving, investment, the US real interest rate, net capital outflows, the real exchange rate, and the trade deficit.
C) Now, consider the small open economy of Norway, which has a trade surplus. If the US, a large open economy, were to reduce its Social Security benefits, use the appropriate graphs to illustrate and state what would happen in the long run to Norway’s national saving, investment, interest rate, real exchange rate, and trade surplus.

Explanation / Answer

the disposable income which individuals desire to spend on consumption is known as propensity to consume. Marginal propensity to consume (mpc) is the proportion of additional income that an individual desires to consume For example, if a household earns one extra dollar of disposable income, and the marginal propensity to consume is 0.65, then of that dollar, the household will spend 65 cents and save 35 cents. Mathematically, the marginal propensity to consume (MPC) function is expressed as the derivative of the consumption (C) function with respect to disposable income (Y). OR , where ?C is the change in consumption, and ?Y is the change in disposable income that produced the consumption. Marginal propensity to consume can be found by dividing change in consumption by a change in income, or MPC=?C/?Y. The MPC can be explained with the simple example: INCOME CONSUMPTION ! 120 120 180 170 Here ?C= 50; ?Y= 60 Therefore, MPC=?C/?Y= 50/60= 0.83 or 83%. For example, suppose you receive a bonus with your paycheck, and it's $500 on top of your normal annual earnings. You suddenly have $500 more in income than you did before. If you decide to spend $400 of this marginal increase in income on a new business suit, your marginal propensity to consume will be 0.8 ($400 / $500). The marginal propensity to consume is measured as the ratio of the change in consumption to the change in income, thus giving us a figure between 0 and 1. The MPC can be more than one if the subject borrowed money to finance expenditures higher than their income. One minus the MPC equals the marginal propensity to save (in a two sector closed economy), both of which are crucial to Keynesian economics and are key variables in determining the value of the multiplier. The MPC is the rate of change in the Average propensity to consume (APC ) . When income increases, the MPC falls but more than the APC. Contrariwise, when income falls, the MPC rises and the APC also rises but at a slower rate than the former. Such changes are only possible during cyclical fluctuations whereas in the short-run ther e is no change in the MPC and MPC

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