Keynesians - AS & AD

Keynes didn't distinguish between the short-run and the long-run as Classical economists tend to. He argued that the economy could settle at any equilibrium level of income at any time, and it was the government job to use appropriate policies to ensure that this equilibrium was a good one for the economy. This can be illustrated on an aggregate supply and demand diagram:

The economy could settle at any of the 4 equilibria shown (Q1 - Q4). Clearly Q1 is not a very desirable equilibrium as the level of output is very low and there would be high levels of unemployment. Nevertheless this situation could, according to Keynes, persist in the long-term unless the government did something to stimulate the economy. This something would have to be some sort of reflationary policy, which boosted the level of aggregate demand (see the next section on policies for more details on the type of policies that could be used). As aggregate demand grows so does the level of output, but as the economy nears full employment the dark spectre of inflation emerges - in other words the price level starts to increase! This inflation is due to an excess level of demand and so is called demand-pull inflation. At the same time there will be increased pressure on the labour market as nearly everyone has a job, and so wages will begin to rise as firms have to offer more to get the people they want. This in turn will cause costs to increase, and result in cost-push inflation.

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