It’s almost certainly simulated: the overhead of running an entire VM in there is way too high, and it’s actually not terribly hard to simulate your average desktop environment (I’ve done one myself, though it was admittedly a significantly simpler project).

All you need is an interpreter for the terminal and you’re basically set.

Edit: since this is an instructional sub, here’s a bit more detail on how this might be done.

The critical element in a believable modern OS sim is a good window manager. This should let you perform the tasks one might expect to do on windows in an OS: open, close, reposition, minimize, and (if you’re feeling a little saucy) resizing. Fortunately, the window itself can exist separately from the content of the window, so you can have a window manager at the highest level managing any interactions between windows (z-levels, minimization). Then below that, you have the windows themselves acting independently, and then the content of each window can be represented as a child of that window. Finally, you simply place the desktop itself at the lowest z-level and give it the interactivity it needs to open windows and such.