Fiscal Policy Simulation

Fiscal Policy Simulation

Government officials play a vital role when it comes to the economy. Decisions that are made determine economic growth or an economic recession. Understanding the economic indicators and how changes in one affects another is important when determining the correct fiscal policy to implement. The challenge is to establish and maintain a growing economy while controlling indicators such as inflation and unemployment, which have an inverse relationship with one another. Governments face these dilemmas everyday, and decisions are not easy because of the ever changing conditions of the economy.

For the year 2XX6 scenario, the government was faced with finding ways to avoid a recession while not allowing the budget deficit to increase to more than five percent of the Gross Domestic Product (GDP). To counteract a possible recession, the government implemented a fiscal policy to increase government expenditure on infrastructure projects by $300 million dollars. This measure increased the budget deficit from 2.5 to 3.25 percent. However, the real GDP of the economy increased from 39.7 billion to 41.2 billion, which is close to the economy's long-run potential output. This decision also increased the president's popularity because inflation remained constant at five percent, while unemployment dropped from 6.32 to 4.5 percent.

In the president's fourth year in office, he along with the government must enact a fiscal policy to drive down rising inflation. Implementing a deflationary policy would reduce incomes in the economy. To combat the high inflation, which was at 10.41 percent, the income tax rate was increased by 3.5 percent. As a result, inflation dropped to 5.16 percent and unemployment increased from 3.53 to 4.43 percent. The income tax increase will increase income tax revenue by $700 million, while leading to a real GDP of $41.26 billion, which is very close to the economy's long-run potential output with the budget deficit was reduced to 2.33 percent of the GDP. With the increase in unemployment, the president's popularity declined because of the government's decision to increase the income tax rate.

In year 2XX9, the government has not had much success in controlling inflation. In order to tackle this recurring problem, the government decides again to raise income tax rate by 2.5 percent. This decision proved to be very successful and enabled the economy to get back on track. The income tax rate increase provided income tax revenues of $500 million, will lowering inflation from 8.98 to 5.23 percent. Implementing this fiscal policy will lead to a real GDP of $41.29 billion, which is close to the economy's long-run potential output while the budget deficit remained constant at 1.81 percent of the GDP. This decision has also put the president back into good favor, as his popularity increased from 2.8 to 3.4.

Four key points from the reading assignments that were emphasized in this simulation were: (1) Unemployment rate; which is the percentage of people in the economy that are not working, but who are able and willing to work. (2) Inflation; which is a continual rise in the price level. (3) Potential output; which is the highest amount of output and economy can produce from the existing production function and the existing resources. (4) Multiplier effect; which is the