Introduction

 

The Virtual Economy is an online internet-based model of the United Kingdom Economy. The economy contains extensive supporting materials which are used for determining the optimal macroeconomic mix in policy formulation. The model was developed by the Institute of Fiscal Studies and Biz/ed group and was supported by the Nuffield Foundation. The developers of the model came from the University of Bristol. Currently, the Virtual Economy model is based on the United Kingdom Chancellor of the Exchequer. Unlike many of the macroeconomic policy simulations, the Virtual Economy is not a game. The virtual Economy is found on “11 Downing Street” which is divided into five floors. Each floor is made up of virtual rooms that contain different resources (Sutcliffe, 2002, pp. 5-8).

 

 The ground floor contains the Chancellor’s office. 1st floor and second floor contain case studies about the impact of variations in the economy on the people, and different economic variables which make up the model respectively. The glossary of the Virtual Economy terms and the different types of economic theory is found on the third floor. The model of the Virtual Economy is found on the fourth floor.

 

In the analysis of the changes of tax policies and interest rate adjustments on the macroeconomic variables, we are going to use the Virtual Economy Model (Colin Grahame Bamford, 2000, p. 14).

 

Impact of introducing tax cuts and interest rate adjustment

 

A change in any variable in the model results to a subsequent change on the macroeconomic variables such as the inflation rate, unemployment rate and economic growth. The Chancellor of the Exchequer is responsible for running the Virtual Economy (Hana Polackova Brixi, 2004, p. 138). An effect of interest rate on the aggregate demand in the economy is used as a monetary policy in United Kingdom. Interest rate is a significant tool in the control of inflation (Pham-Gia, 2009, p. 7).

 

In carrying out the analysis, the income tax has been reduced to 6% and income tax is 10%.  The target inflation rate is zero. The changes in the macroeconomic variables as a result of tax cuts and interest rate adjustments are summarized in the following table.

Macroeconomic variables

2003

2004

2005

2006

Before

After

Before

After

Before

After

Before

After

Economic Growth (GDP growth in %)

2.79

38.08

2.50

23.91

2.41

18.17

2.55

14.93

Unemployment (% of the work force)

3.50

-0.81

3.70

-11.91

3.80

-20.63

3.90

-25.42

Inflation (%)

2.07

9.47

2.18

51.40

2.35

61.34

2.24

52.13

Government Debt

37.20

17.84

36.50

-30.83

35.70

-116.80

34.90

-231.35

Government Borrowing

1.00

-4.81

0.90

-39.47

0.90

-52.05

0.90

-63.72

 

 

 

Macroeconomic variables

2007

2008

2009

Averages

Before

After

Before

After

Before

After

Before

After

Economic Growth (GDP growth in %)

2.61

10.89

2.52

8.21

2.50

6.81

2.53

11.13

Unemployment (% of the work force)

3.90

-26.56

4.00

-25.82

4.00

-25.54

3.79

-9.83

Inflation (%)

2.23

40.66

2.25

30.32

2.25

21.81

2.23

23.19

Government debt

34.00

-363.79

33.20

-500.91

32.40

-627.51

37.97

-136.81

Government borrowing

0.90

-63.72

0.80

-68.50

0.80

-69.38

0.11

-27.18

 

The changes in government policy, tax cuts and interest rate adjustment, have different impacts on the macroeconomic variables. From the analysis, the average growth in Economic growth, in % would increase from 2.53% to 11.13%. The unemployment, as a % of the work force, would decrease from 3.79% to -9.38%. The government policy would be undesirable in the case of inflation. The average level of inflation would increase from 2.23% to 23.19%. Average government debt and average government borrowing would decline to -136.81% and -27.18% respectively (Langdana, 2009, p. 8).  

 

 

There is a negative relationship between the interest rate and investment. A decrease in interest rate leads to an increase in the growth rate as shown in the diagram. Beyond certain point, liquidity preference will set in and the increase in growth will not continue. It will be inappropriate to reduce interest rate.

 


 

  

Tax cuts leads to an increase in employment. This is because of the reduction in production cost of the firms. As a result, unemployment decreases.

 


 

 

The high aggregate demand of commodities as a result of increase in employment leads to an increase in price, leading to increase in inflation. At full employment, firms will not hire more workers. This will lead to a decline in inflation.

 


 

 

Reduction in interest rate and tax cuts will lead to an increase in the interest payable on the debt. The government will be able to pay off the loans.

 


 

 

 

Due to the increase in the economic growth, the output will increase in the economy reducing the need for borrowing.

 


 

According to Classical Economists, a Contractionary fiscal policy leads to a decrease in the net exports. A decrease in the amount of tax revenue decreases the income tax paid by the firms. On the other hand, Keynesian Economists argue that aggregate demand can be stimulated by the decrease in tax rates. The cost of production is reduced. The firm can be able to hire additional workers resulting to a reduction in the unemployment level (Roy, 2005, pp. 95-156). The decrease in the unemployment level leads to an increase in the real wage among the workers. The purchasing power of consumers will increase. Consequently, the demand for commodities increases leading to an increase in the inflation level (Mohsin Khan, 2002, p. 7).

 

In the case where there are no changes in the government policies, the macroeconomic variables will remain the same from 2003 to 2009 as per the Virtual Economy Simulation. The average for the macroeconomic variables is shown in the following table (Buti, 2003, p. 158).

Macroeconomic variables

Averages

Before

After

Economic Growth (GDP growth in %)

2.53

2.53

Unemployment (% of the work force)

3.79

3.79

Inflation (%)

2.23

2.23

Government debt

37.97

37.97

Government borrowing

0.11

0.11

 

Part B

Fiscal policy involves changes in taxation and government spending in order to achieve equilibrium level of output. Fiscal policy aims to create variations in the macroeconomic variables in order to obtain a desirable level of economic growth. On the other hand, monetary policy refers to the adjustment of the interest rate in the economy in order to control the money supply in the economy. Money supply in the economy plays a significant role in determining the aggregate demand (Zalduendo, 2005, p. 10). High amount of money in supply increases the aggregate demand for the commodities which lead to increase in the level of inflation. A decrease in the amount of money is an effective mechanism of reducing the level of inflation. A good economic policy mix should lead to an increase in the economic growth rate, decrease in inflation and unemployment. The amount of government debt and government borrowing should decline (Devereux, 2005, p. 27).

 

The best economic policy mix would be reducing the interest rate by 6% and the basic income tax by 10%. The interest rate to be used to control inflation and the inflation rate target to be 1%, and government expenditure to be reduced by 5%. The combination of the economic policy mix yields the following results (Pavel Pelikán, 2003, p. 15).

Macroeconomic variables

2003

2004

2005

2006

Before

After

Before

After

Before

After

Before

After

Economic Growth (GDP growth in %)

2.79

37.79

2.50

24.05

2.41

18.28

2.55

15.06

Unemployment (% of the work force)

3.50

-0.64

3.70

-11.73

3.80

-20.44

3.90

-25.26

Inflation (%)

2.07

9.41

2.18

51.41

2.35

61.40

2.24

52.50

Government Debt

37.20

17.81

36.50

-31.22

35.70

-117.69

34.90

-232.95

Government Borrowing

1.00

-5.09

1.00

-24.36

0.90

-39.88

0.90

-52.55

 

 

 

Macroeconomic variables

2007

2008

2009

Averages

Before

After

Before

After

Before

After

Before

After

Economic Growth (GDP growth in %)

2.61

11.03

2.52

8.35

2.50

6.93

2.53

11.17

Unemployment (% of the work force)

3.90

-26.48

4.00

-25.86

4.00

-25.72

3.79

-9.79

Inflation (%)

2.23

40.74

2.25

30.41

2.25

21.91

2.23

23.22

Government debt

34.00

-232.95

33.20

-504.80

32.40

-632.89

37.97

-138.03

Government borrowing

0.90

-64.37

0.80

-69.30

0.80

-64.49

0.11

-27.50

 

However, holding tax cuts and interest rate adjustments constant, a reduction in the government spending by 5% would yield consistent results. However, reduction in government spending leads to a higher level of inflation, 23.22% as compared to 23.19%. There is no significant difference. In both scenarios, a decrease in tax increases the amount of real wage available to consumers. This leads to an increase in demand for the product leading to an increase in price (Carbaugh, 2010, p. 303).

 

According to Keynesian Economist, government spending may create inflation or encourage the existing inflation to persist. This happens in situations of low unemployment. Increase in government spending increases the market output, which creates income (Tucker I. B., 2010, p. 332). As a result, consumer spending will increase. This creates an excess demand for the products through the multiplier effect, which leads to an increase in price (Tucker, 2008, p. 239).

 

The economic policy mix will lead to a rise in the employment of labor due to the reduction in tax. Business output increases due to changes in government spending. GDP will increase (Benoît Coeuré, 2010, p. 152).

According to the Keynesian Stimulus Myth, holding tax cuts and interest rate adjustments constant, a decrease in government expenditure by 5% leads to an increase in economic growth.

 


 

Increase in output implies firms must hire extra workers to carry out the production. This leads to an increase in employment level.

 


 

Increase in the amount of real wage leads to an increase in aggregate demand. The increase in aggregate demand increases the price level leading to inflation up to the point of full employment.

 


 

A reduction in the government spending by 5% leads to a decline in the amount borrowed. Decrease in the government expenditure yield similar results as tax cuts and interest rate adjustments.

 


 

Reduction in government spending by 5% will automatically lead to the amount borrowed.

 


 

 

 

 

Works Cited

Benoît Coeuré, P. J. (2010). Economic Policy: Theory and Practice. London: Oxford University Press.

Buti, M. (2003). Monetary and Fiscal Policies in EMU: Interactions and Coordination. Cambridge: Cambridge University Press.

Carbaugh, R. J. (2010). Contemporary Economics: An Applications Approach. New York: M.E. Sharpe.

Colin Grahame Bamford, S. G. (2000). The UK Economy in a Global Context. Oxford: Heinemann.

Devereux, M. B. (2005). Asymmetric Effects of Government Spending: Does the Level of Real Interest Rates Matter?, Issues 2005-2007. Washington: International Monetary Fund.

Hana Polackova Brixi, Z. L. (2004). Tax Expenditures--shedding Light on Government Spending Through the Tax System. Washington : World Bank Publications.

Langdana, F. K. (2009). Macroeconomic policy [electronic resource]: demystifying monetary and fiscal policy. New York: Springer.

Mohsin Khan, S. N.-H. (2002). Macroeconomic management: programs and policies. Washington: International Monetary Fund.

Pavel Pelikán, G. W. (2003). The evolutionary analysis of economic policy. New York: Edward Elgar Publishing.

Pham-Gia, K. (2009). Automatic stabilizers for fiscal policy. Norderstedt: GRIN Verlag.

Roy. (2005). Macroeconomic Policy Environment. New Delhi: Tata McGraw-Hill Education.

Sutcliffe, M. (2002). Simulations, Games and Role-play. The Hadbook of Economic Lecturers , 5-8.

Tucker, I. B. (2008). Macroeconomics for Today. South Melbourne: Cengage Learning.

Tucker, I. B. (2010). Survey of Economics. South Melbourne: Cengage Learning.

Zalduendo, J. (2005). Pace and Sequencing of Economic Policies, Issues 2005-2118. Washington: International Monetary Fund.

 

 

 

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