The Keynesian AS Curve

The Keynesian Aggregate Supply curve is a distinctive feature of Keynesian macroeconomics. Unlike the classical vertical LRAS, the Keynesian AS curve has three distinct sections, each with different implications for the effectiveness of demand management policy. Understanding this curve is essential for analysing output gaps, the impact of fiscal and monetary policy, and the debate between Keynesian and classical economists.

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The Three Sections of the Keynesian AS Curve

The Keynesian AS curve reflects the idea that the economy's response to increases in aggregate demand depends on how close the economy is to full capacity:

Section 1: The Horizontal (Perfectly Elastic) Section

Feature	Explanation
Shape	Flat/horizontal
Economic conditions	Significant spare capacity — high unemployment, idle factories, unused capital
Response to AD increase	Output increases with no increase in the price level
Why?	Firms can hire unemployed workers at the prevailing wage rate. There is no upward pressure on wages or prices because resources are abundant and easily available.
Policy implication	Demand management is highly effective — an increase in G or a cut in interest rates translates fully into higher output and employment, with no inflation

This section represents the economy in deep recession — the situation Keynes was analysing during the Great Depression of the 1930s, when unemployment in the UK reached over 20%.

Exam Tip: The horizontal section is the strongest case for Keynesian demand management. In this zone, increasing AD raises output and employment without causing inflation. This is the theoretical justification for expansionary fiscal policy during recessions.

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Section 2: The Upward-Sloping (Intermediate) Section

Feature	Explanation
Shape	Upward-sloping
Economic conditions	The economy is approaching full capacity — some sectors and regions have spare capacity while others are experiencing bottlenecks
Response to AD increase	Output increases but the price level also rises
Why?	As the economy approaches full employment, some factor markets become tight. Skilled workers may command higher wages. Firms face rising marginal costs as they push towards capacity. Some industries hit supply constraints before others.
Policy implication	Demand management still increases output, but at the cost of some inflation — there is a trade-off

This section represents the economy in normal times — neither deep recession nor full boom. Most real-world economies operate somewhere along this section.

Bottleneck Inflation

As AD increases along the upward-sloping section, bottleneck inflation occurs because:

1. Labour market bottlenecks — skilled workers in high-demand sectors (e.g., technology, healthcare) command wage premiums, even while unemployment persists elsewhere
2. Sectoral imbalances — some industries hit capacity before others, leading to price increases in those sectors
3. Regional disparities — London and the South East may be near full employment while other regions have significant spare capacity
4. Supply chain constraints — shortages of specific inputs (semiconductors, building materials) create localised price pressures

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Section 3: The Vertical (Perfectly Inelastic) Section

Feature	Explanation
Shape	Vertical
Economic conditions	Full employment — all factors of production are fully utilised
Response to AD increase	The price level rises with no increase in real output
Why?	The economy cannot produce more because all resources are employed. Extra spending simply bids up the prices of existing output.
Policy implication	Demand management is completely ineffective at increasing output — it only causes inflation. Only supply-side policies can increase output by shifting AS to the right.

At this point, the Keynesian and classical views converge — both agree that at full employment, increases in AD are purely inflationary.

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The Output Gap

The output gap is the difference between the economy's actual output and its potential (full employment) output:

Type of Gap	Definition	Location on Keynesian AS
Negative output gap (deflationary gap)	Actual output < potential output	Economy is on the horizontal or early upward-sloping section
Positive output gap (inflationary gap)	Actual output > sustainable potential output	Economy is beyond full employment — unsustainable overheating
Zero output gap	Actual output = potential output	Economy is at full employment

UK Output Gap Estimates

Period	Estimated Output Gap	Context
2009	Approximately −6%	Deep recession following the financial crisis
2012–2013	Approximately −2 to −3%	Slow recovery, austerity
2019	Approximately 0%	Near full employment
2020 Q2	Approximately −25%	COVID lockdown — the largest output gap in modern history
2022	Approximately +1%	Post-COVID recovery, tight labour market