Chapter 9 · Aggregate demand and aggregate supply
Keynesian inflationary gap
Explain why higher aggregate demand raises prices rather than real output at full capacity in the Keynesian aggregate supply model.
The economic idea
The Keynesian model emphasises that an economy can remain below full employment because aggregate demand is insufficient. Nominal wages and prices may be sticky downward, so market forces do not necessarily restore full employment quickly or automatically.
The Keynesian aggregate supply curve shows the relationship between the average price level and the real output firms produce. It has three stylised sections because the availability of idle resources changes as production expands.
On the horizontal section, extensive spare capacity allows firms to raise output without bidding strongly against one another for scarce labour and inputs. An increase in aggregate demand therefore raises real output with little or no increase in the price level.
On the upward-sloping section, some industries approach capacity before others. Bottlenecks, overtime and less-suitable resources raise marginal costs, so stronger aggregate demand increases both real output and the price level.
On the vertical section, the economy is at maximum full-employment output. All suitable resources are fully employed at normal sustainable rates, so an increase in aggregate demand raises the price level but cannot increase real output.
At maximum capacity, further nominal spending creates demand-pull inflation rather than additional real production. The economy needs capacity growth, lower demand pressure or a favourable supply change to avoid this price effect.
Reading inflationary equilibrium on the vertical section
“Price level” measures the economy-wide price level and “Real GDP” measures real GDP.
“AD” shows total planned expenditure at each price level. “Keynesian AS” shows how much real output firms can produce across different degrees of spare capacity.
“E” is where “AD” intersects “Keynesian AS”, determining “PLₑ” and “Yₑ” in the current graph.
Why Keynesian AS changes shape
The horizontal part of “Keynesian AS” represents extensive spare capacity, the curved middle represents increasingly binding bottlenecks, and the vertical part represents maximum full-employment output. The curve therefore embeds a changing output response rather than one constant slope.
Current equilibrium: E
“E” lies on the vertical section of “Keynesian AS” at maximum capacity. Additional aggregate demand cannot raise real output beyond “Yₑ” in this model, so it raises the price level instead.
What a change in aggregate demand would do here
Near “E”, a rightward shift of “AD” would raise the price level without raising real output because “Keynesian AS” is vertical at capacity.
Extra spending cannot create resources immediately
At the vertical section, a higher willingness to spend bids up prices for the output available. It does not immediately create the skilled workers, equipment or infrastructure needed to produce more.
Distinguish reducing demand pressure from increasing productive capacity. Demand restraint may limit price pressure sooner, while supply-side improvements take time and depend on the policy used.
Trace demand through the section of AS that is actually visible
Locate “E” where “AD” intersects “Keynesian AS”; do not infer the state from the diagram title alone.
Because “E” is at the capacity boundary or on the vertical section, the economy cannot sustainably raise real output through higher aggregate demand alone.
A change in planned expenditure changes the price level rather than real output because productive capacity is binding.
Evaluate the result using the size of spare capacity, the multiplier, import and tax leakages, confidence, time lags and possible changes in productive capacity.
Common mistakes to avoid
- The horizontal section of “Keynesian AS” does not mean every individual price is fixed; it represents little change in the average price level while aggregate output expands from deep spare capacity.
- Full employment does not mean zero unemployment. Frictional and structural unemployment may remain.
- A point on the upward-sloping section can still show a recessionary gap because output remains below the vertical capacity line.
- An increase in aggregate demand at full employment creates inflationary pressure, not long-run economic growth.
- The Keynesian AS curve is a stylised model. Real economies do not have perfectly sharp boundaries between all three ranges.
How to draw this diagram
- Title the diagram “Keynesian inflationary gap”. Label the horizontal axis “Real GDP” and the vertical axis “Price level”.
- Draw AD first and label it clearly.
- Draw Keynesian AS next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Add the relevant guide lines and shade the economic area only after its boundaries are established.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The three sections are stylised and their boundaries cannot be observed with certainty in real time.
- Spare capacity can coexist with sector-specific shortages, so inflation may appear before national full employment.
- The curve does not show how expectations, exchange rates or imported inflation alter the price response.
- Demand stimulus can change productive capacity through investment or hysteresis, rather than moving only along a fixed AS curve.
- The model aggregates distributional effects: households can experience very different employment and inflation outcomes.