Virtual Economy – Government Policy and Outcomes
Within our model we have changed five variables (as shown in figure 1): lowered the basic rate of income tax to 20%, lowered VAT to 12% and increased government spending on health, education and employment, and defence each by 5%. This report will explain the impact upon mainly 3 economic indicators: unemployment, inflation and government debt, before analysing different implications on the economy. It should be appreciated that the government targets for these three factors are low unemployment, low inflation and low government debt, although recently this target has become to reduce government debt. It should also be noted that ...view middle of the document...
This is derived from Fischer equation of exchange: MV=PT. As taxation is a withdrawal and government spending is an injection (from and into the economy) we can assume that the money supply is being increased. This suggests another reason why inflation is predicted to increase dramatically.
As we have previously established, the expansionary policy will cause AD to rise, which causes business’ to expand production in response to increased demand. This leads to the creation of jobs and therefore decreased the claimant count. By running multiple single variable models we can conclude that the decreased rate of VAT has the most significant impact upon reducing unemployment, this is likely to be due to business’ growth as revenues can increase by up to 8% (assuming no price changes). However, as seen in figure 3 the unemployment level starts to rise again during 2007, this can be explained by the monetarist Philips curve theory. As seen in figure 9, the Philips curve shows that when unemployment reduces, inflation will rise is due to increased demand in the economy. However, as workers realise this inflation due to the decreased purchasing power of their wages, there becomes less of an incentive to work, causing unemployment to rise again. Businesses also realise that due to inflation there is no real increase in demand, leading to the redundancy of workers and increased unemployment (This process can be seen on figure 9 as the movement from A to B to C). The Philips curve ultimately suggests that an economy cannot operate at lower unemployment than the long run Philips curve (LRPC) rate, any attempt to lower unemployment past this rate will be inflationary in the short term, but according to Chang (1997) it does not affect inflation in the long term.
Figure 4 shows predicted government debt/GDP ratio to be higher for approximately 3 years from the placement of the new policies. This is due to expansionary policy leading to less tax revenues and higher spending which in turn increases the government debt. However, the less expected attribute of this prediction occurs beyond 2006, where government debt/GDP ratio is predicted to fall. According to Aizenman and Marion (2009) governments can use inflation to lower the government debt/GDP ratio. They conducted an empirical study which showed that a rate of inflation of 6% can reduce the debt/GDP ratio by up to 20% in 4 years. As we can see in figure 3 inflation is predicted to stand above 5% for around 5 years, reaching a peak of 7.5%, it is clear that according to Aizenman and Marion (2009) government debt can be reduced dramatically over the 5 year period shown in figure 8.
Implications on the economy
Inflation of up to 7.5% will have several implications on the economy; some have previously been mentioned within the report (when it affects other variables we are talking about). Firstly, when an economy experiences high levels of inflation, it can lose its...