How Does Keynesian Aggregate Supply Work?
Aggregate demand and supply
What you will learn
- The Keynesian model links demand's effect to spare capacity.
- Compare demand policy across levels of capacity use
Essential definitions
- Keynesian aggregate supply
- An AS representation with a relatively flat spare-capacity region, an intermediate region and a steep or vertical capacity region.
- Deflationary gap
- A shortfall of actual output below full-employment output in the relevant model.
Why the curve changes slope
Keynesian aggregate supply describes how output responds as spare capacity is used up. Put real GDP on the horizontal axis and the price level on the vertical axis. At low output, many workers and machines are idle. Firms can expand without large cost increases, so the curve is relatively flat. This does not mean every individual price is fixed.
As production rises, some sectors run out of skilled workers or equipment before others. Overtime and shortages raise costs, so the middle region slopes upwards. At full capacity, existing resources cannot sustainably supply much more. The curve becomes very steep or vertical. Mark that capacity boundary; the flat section cannot continue indefinitely.
Why unemployment can persist
AD meets Keynesian AS at the output firms expect to sell. If that intersection lies in the flat region, firms have spare capacity but little reason to expand. Unemployed workers cannot create enough spending merely by wanting jobs. Unlike rapid neoclassical self-correction, this model allows weak demand and unemployment to persist.
Suppose actual output is 450 billion against capacity of 600 billion. A rightward AD shift can increase sales and production to 480 billion with little price pressure in the flat region. The remaining shortfall is still 120 billion. The economy has recovered partly; it has not reached full capacity.
Use the starting position to judge policy
Compare the same AD increase in each region, labelling the initial intersection E1 and the new one E2. In the flat region, output and employment rise strongly. In the upward-sloping region, output and prices rise. Near capacity, the price effect dominates. Demand policy therefore needs a diagnosis of spare capacity.
Training and investment can move the capacity boundary right over time, as the growth diagram shows. They do not guarantee extra sales today. Also, shortages in particular industries can cause price pressure while overall unemployment remains high. Use the model to explain the assumed conditions rather than treating its curve as a universal prediction.
Hypothetical spare-capacity expansion
- Potential output is 600 billion, while current output is 450 billion in the flat AS region.
- An AD increase raises equilibrium output to 480 billion at an unchanged modeled price level.
Actual output increases by 30 billion, but a 120-billion shortfall below potential remains.
Keynesian aggregate supply
Initial AD: P = 130 − 0.8Y. Selected AD: P = 190 − 0.8Y. E2: Y=113.89, P=98.89, on the rising costs segment. Capacity is fixed at 120.
At low demand, unemployed factors allow output to rise with little pressure on costs. As bottlenecks emerge AS slopes upward; at full capacity further AD increases raise prices without raising output.
How to draw it and model assumptions
- Draw a flat, then rising, then vertical AS curve.
- Intersect each AD curve with the appropriate segment; mark initial E1 and new E2.
- Compare an identical demand increase at different initial levels of spare capacity.
Stylized three-section Keynesian curve; fixed capacity Y=120. Wage rigidity and weak demand can sustain underemployment equilibrium. This is not a vertical-LRAS adjustment model.
Output gaps and classical adjustment
AD: P = 150 − 0.8Y. SRAS: P = 20 + 0.8Y. E2: Y=81.25, P=85. Short-run gap=-18.75%. After input costs adjust, the long-run position has Y=100 and P=70.
AD and SRAS can intersect away from potential in the short run. Below potential, unemployment can reduce wage growth and unit costs; SRAS moves down until output returns to potential. Above potential, input-cost pressure shifts SRAS up.
How to draw it and model assumptions
- Mark Yp with vertical LRAS.
- Mark initial E1 at potential, then short-run E2 left or right of Yp after the demand shock.
- Shift SRAS to the long-run position on LRAS; retain E2 so the temporary output gap stays visible.
Adjustment assumes flexible wages and prices over time, unchanged AD and unchanged capacity. It is not automatic or rapid under Keynesian assumptions.
Long-term shifts of Keynesian AS
Capacity rises from 120 to 144. AD remains P = 180 − 0.8Y. Initially Y=108.33, P=93.33; after the capacity change Y=119.39, P=84.49. On the rising segment AS₂ is P = Y/1.2 − 15.
Investment in productive capacity moves the rising and full-capacity portions of Keynesian AS right. At a given level of AD, output can be higher and price pressure lower; in a deep recession an increase in capacity alone may leave actual output unchanged.
How to draw it and model assumptions
- Draw the initial three-section AS curve.
- Move the bottleneck and vertical capacity sections right to show more capacity.
- Keep AD fixed and compare initial E1 with new E2.
Fixed AD, hypothetical capacity expansion with the flat-section price floor unchanged. Idle resources and sticky input prices persist in the low-output segment.
Apply and evaluate
- Demand management can be powerful with idle resources, but lags and inaccurate capacity estimates may cause overshooting.
- Sectoral bottlenecks can cause price pressure even while aggregate unemployment is high.
Common misconceptions
- The flat region is not a claim that resources are unlimited.
- Keynesian equilibrium need not occur at full employment.
Knowledge check
Why does the same AD increase have a larger price effect near capacity?
Real-world application
Energy costs and aggregate supply
16 November 2022: ONS reported that gas and electricity prices made the largest upward contribution to the change in UK annual consumer-price inflation between September and October 2022.
Model application: dearer energy can raise firms’ unit costs, shifting SRAS left. It also reduces households’ purchasing power, which can weaken demand. The observation alone does not identify the size of either shift or prove all inflation had one cause.
ONS, Consumer price inflation, UK: October 2022 ↗Historical evidence checked 9 October 2026. The model interpretation is an original teaching application.
What to remember
The Keynesian model links demand's effect to spare capacity. Extra spending mainly raises output when resources are idle and mainly raises prices near full capacity.
Completion is your own reflection on learning, not a test score. Syllabus references: 3.2.11, 3.2.13, 3.2.16, 3.2.17.
Lessons in this section
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