Macroeconomics: AD-AS Model and Policies

This assignment delves into macroeconomic concepts using the Aggregate Demand (AD) and Aggregate Supply (AS) model. Students analyze how shifts in AD and AS affect price levels, real GDP, and unemployment. The impact of various policies, such as expansionary/contractionary monetary and fiscal policy, is also examined within this framework.

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by (Name)
The Name of the Class (Course)
Professor (Tutor)
The Name of the School (University)
The City and State where it is located
The Date

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PART A:
1. Economies of scale are the benefits a firm obtains from expansion. In other words, as a
company grows and increases production, the company is likely to experience a decrease
in its costs. Economies of scale play a significant role in forming market types such as
oligopoly and monopoly. An oligopoly is a market type that consists of only a few sellers
or producers. The small number of firms in an oligopoly are capable of producing at a
lower average cost an output level that forms a considerable portion of the whole
available market. The auto industry is a good example of an oligopoly that gains from
economies of scale.
Economies of scale can also form a monopoly, a market structure consisting of only
one seller of a specific product. The single dominant firm in a monopoly is capable of
producing at a low average cost at a given output level that is sufficient to meet the
product demand of the entire market. The electric power industry is an example of a
monopoly that benefits from economies of scale. On the other hand, there is no scope for
economies of scale in a perfect competition because of the many small firms producing
relatively little amounts, thus no one firm benefits from large-scale production. Similarly,
a monopolistic competition, which consists of firms selling differentiated products, can
lead to saturation of firms, which means that players are unable to make the most of the
economies of scale (Referenceforbusiness.com, 2017).
2. In 2002/03, the airline industry was operating as an oligopoly with only a few players in
the industry. For instance, Qantas Airways Group and Virgin Blue Airlines were the two
major players in the airline industry in Australia. The two firms controlled the three
major categories in the industry: domestic trunk, regional, and international (Aph.gov.au,
2017). An oligopoly market situation consists of a few interdependent companies sharing
the market. The actions and reactions of competitors are taken into account when

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forming decisions. Furthermore, there exist few barriers to entry and exit. Also,
oligopolies thrive on customer loyalty hence heavy advertising is the mantra (Agarwal,
2017).
3. A mutual benefit by Qantas and Virgin could be established in a Nash equilibrium
strategy. Nash equilibrium is a term coined after John Nash a mathematician who
described an equilibrium scenario whereby each participant wins because they derive the
outcome they desire. If no participant changes their strategy, then a Nash equilibrium is
achieved. For instance, Qantas and Virgin could adopt a cost-plus pricing strategy as a
pricing rule. In this method, a firm determines its cost of production and then adds the
desired profit margin by a markup. Cost-plus pricing can be explained through the
application of the Nash equilibrium. If one dominant firm uses cost-plus pricing method,
then the rest may follow suit so that the strategy becomes the rule (Guo, 2017).
PART B:
1. France’s economy is in the third phase of the business cycle, known as contraction. In
general, a contraction is a period of sluggish economic activity (The Balance, 2017). At
this phase, the economic growth weakens, the GDP growth rate falls below 2 percent,
and the unemployment rate is high and could reach 10 percent. Also, during a
contraction, the inflation rate tends to be lower as evidenced by France’s economy,
which is slightly below 1 percent (Tradingeconomics.com, 2017).

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2.
Figure 1: AD/AS model for the French economy in 2017
Fig. 1 illustrates a shift in the AD to the left, from AD0 to AD1. A shift in AD to the left
establishes a new equilibrium E1 which will result in a lower output and also a lower price
level compared to the initial equilibrium E0. A decrease in government spending or
increase in taxes leads to a decrease in consumer spending and a decrease in the AD to the
left.
3. According to the AD/AS model, an increase in government spending, investment,
consumption or exports can lead to an increase in aggregate demand thus higher
economic growth. Ideally, the French government should be trying to increase the
aggregate demand through government spending and an overhaul of the tax system.
Furthermore, the unsound monetary policy favored in the euro-zone is detrimental to
France’s economy (Luke, 2011).
4. The French economy is performing in dismal with high unemployment and weak

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economic growth. For this reason, the government should implement an expansionary
fiscal policy in order to stimulate the economy. In this scenario, the government would
increase spending and reduce taxes. The government could increase spending in the form
of benefits and public employment while encouraging a budget deficit by reducing taxes
(Michaillat and Saez, 2013). In Fig. 2, an increase in government spending and a
reduction in taxes shifts the AD(Aggregate Demand) to the right, from AD1 to AD2.
This shift also sets a new equilibrium E2 which results in a higher output and higher
price level from P1 to P2.
Figure 2: Expansionary Fiscal Policy effect
5. The EU requires that member countries cap their annual budget deficit to 3 percent of
GDP and manage a debt of 60 percent of GDP. France’s current debt to GDP is at 96
percent while its budget deficit is slightly above the requirement at 3.4 percent of GDP.
This means that France is on the right track in terms of budget deficit but there is a
deviation in its debt to GDP (Tradingeconomics.com, 2017).
6. The European Central Bank(ECB) is the institution with the mandate in monitoring the

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monetary policy in France and other eurozone member states. Also, eurozone members
such as France operate under the euro as the official currency (Bank, 2017).
7. An Expansionary Monetary Policy is necessary when an economy is in the contraction
phase of the business cycle. In order to stimulate economic growth, more money needs to
be put into peoples pocket, thus a reduction in the interest rates would be a prudent
move. Lower interest rates reduce the cost of borrowing, reduces the cost of mortgages
and other interest repayments, and increases the demand for export goods. In addition,
the monetary authorities could also lower the reserve requirement held by banks and
purchase securities from banks and other security firms. An expansionary monetary
policy would trigger economic growth hence increase the aggregate demand by shifting
it to the right (Moffat, 2017).
8. In the long run, Improving workers’ skills through education and investment in
infrastructure would boost economic growth. For instance, skilled workers demand
higher wages and increase employment. This upgrade in the productivity of labor would
be beneficial to the overall economy due to the improvement in skill level, training, and
education. Furthermore, infrastructure is the foundation of economies since good
infrastructure has a multiplier effect on the overall economy (Luke, 201). For example,
better infrastructure creates better business environment due to improved efficiency.
Also, jobs will be created in the process which would increase consumer spending
leading to economic growth. Fig. 3 illustrates a boost in economic growth by shifting the
LRAS(Long run average supply) curve to the right from LRAS0 to LRAS1 and the AD
to the right, from AD0 to AD1. Also, economic growth is illustrated by an increase in the
GDP output from Y0 to Y1 but the same price is maintained because in the long run
firms and consumers are well aware of the prices, so the GDP output will be determined
by other factors such as, labor, capital, technology and natural resources but not on the

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price level. This also explains why the long run aggregate supply curve is inelastic.
Figure 3: Long run effect of educating workers and improving
infrastructure

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References
Agarwal, P. (2017). Market Structure: Oligopoly | Intelligent Economist. [online] Intelligent
Economist. Available at: https://www.intelligenteconomist.com/market-structure-
oligopoly/ [Accessed 13 Sep. 2017].
Aph.gov.au. (2017). Australian Airline Industry – Parliament of Australia. [online]
Available at:
http://www.aph.gov.au/About_Parliament/Parliamentary_Departments/Parliamentary_Libr
ary/pubs/rp/rp0203/03RP10#aair [Accessed 13 Sep. 2017].
Bank, E. (2017). Monetary Policy. [online] European Central Bank. Available at:
https://www.ecb.europa.eu/mopo/html/index.en.html [Accessed 18 Sep. 2017].
Economics.fundamentalfinance.com. (2017). Nash Equilibrium and Dominant Strategies-
Game Theory - Fundamental Finance. [online] Available at:
http://economics.fundamentalfinance.com/game-theory/nash-equilibrium.php [Accessed 13
Sep. 2017].
Guo, V. (2017). Cost Plus Pricing 101: The Necessities and Your Pricing Strategy. [online]
Priceintelligently.com. Available at:
http://www.priceintelligently.com/blog/bid/161014/cost-plus-pricing-101-the-necessities-
and-your-pricing-strategy [Accessed 13 Sep. 2017].
Luke, J. (2017). AD-AS Model Explained. [online] Available at:
https://econproph.com/2011/03/02/ad-as-model-explained/ [Accessed 19 Sep. 2017].
Michaillat, P. and Saez, E. (2013). A theory of aggregate supply and aggregate demand as
functions of market tightness with prices as parameters. Cambridge, Mass.

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Moffat, M. (2017). Expansionary vs. Contractionary Monetary Policy. [online] Available at:
https://www.thoughtco.com/expansionary-vs-contractionary-monetary-policy-1146303
[Accessed 18 Sep. 2017].
The Balance. (2017). The 4 Critical Stages of the Business Cycle. [online] Available at:
https://www.thebalance.com/what-is-the-business-cycle-3305912 [Accessed 14 Sep.
2017].
Tradingeconomics.com. (2017). France | Economic Indicators. [online] Available at:
https://tradingeconomics.com/france/indicators [Accessed 14 Sep. 2017].
Theweek.com. (2017). Emmanuel Macron has misdiagnosed France's ailing economy.
[online] Available at: http://theweek.com/articles/705135/emmanuel-macron-
misdiagnosed-frances-ailing-economy [Accessed 13 Sep. 2017].