The Virtual Economy Model

The economic model used in Virtual Economy is based on the public release of the Treasury model. The full version of the model is very complex and is solved on a powerful mainframe computer at the University of Warwick. Much of the complexity derives from the simultaneity in the model. For example a change in interest rates has a direct impact on prices. This in turn feeds into output and unemployment which themselves feed back onto prices. This starts the sequence off again. The model is run until all variables settle on new paths. This property of the Treasury model means it is an example of a 'structural form'. Its equations describe all the relationships and feedbacks between economic variables that its builders perceive to exist in the actual economy. However, solution of the model can take some time - not an ideal feature of a Web based model.

The Virtual Economy model is an example of a 'reduced form'. Effectively the complex equations of the Treasury model are rewritten in a form that no longer describes the linkages as they appear in the actual economy but in a manner which lends itself to a quick solution. Interest rates now have a direct effect on the level of GDP where in the full model the impact comes separately through the individual equations for consumption, investment and the other components of the GDP identity. The impact of the individual policy changes are calculated on the full Treasury model. Unit shocks to each of the policy instruments are conducted and the impact on the output variables noted. When the user chooses their policy package the VE model compares the size of the input shocks to the unit shock and scales the results for the output variables.

Although care has been taken to ensure that the properties of the simplified model resemble those of the full Treasury model there are several reasons why they might differ.

• Base dependency. The multipliers calculated from the full model are the result of simulations using a different base forecast to that featured in VE.
• Nonlinearity. VE is linear and a two unit shock is assumed to be equivalent to twice a one unit shock. In the (nonlinear) Treasury model this need not be the case.
• Independence. VE assumes that the result of two shocks is simply the sum of their individual effects. Again this ignores any possible interaction that might exist in the full model.
• Periodicity. The full model is quarterly while VE is annual. Some information is inevitably lost in making this transition.

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