Keynesian analysis of unemployment and inflation

In simply Keynesian theory, it is assumed that there will be a

maximum level of national output, and hence real income, that

can be obtained at any one time. If equilibrium level of income

is at this level, there will be no deficienc of aggregate demand

and hence no disequilibrium unemployment.

Full-employment level of national income is the level of national

income at which there is no deficiency demand.

Deflationary gap is the shortfall of national expenditure below

national income ( and injections below withdrawals) at the

full-employment level of national income.

As you can see on the diagram above if the equilibrium level

of national income (Ye) is below the full-employment level (Yf)

there will be excess capacity in the economy and hence

demand-deficient unemployment.

The inflationary gap is the excess of national expenditure over

income (and injections over withdrawals) at the full-employment

level of national income.

As you can see on the second diagram above if at the full-employment

level of income, national expenditure exceeds national income, there

will be a problem of excess demand.

Keynesians advocate an active policy of demand management:

raising aggregate demand (for example, by raising government

expenditure or lowering taxes) to close a deflationary gap and

reducing aggregate demand to close an inflationary gap.