I had this issue despite having the correct configuration, and realized that the actual problem was that the focus was on the emulator control buttons windows, as reported in this issue.
To check if this is your problem, see if pressing space actually presses one of those buttons, and if pressing tab moves the highlight focus square between elements in the emulator controls. If that is the problem, then you should be able to work around it as follows:
- Select the extended controls (The "..." button in the emulator controls)
- Change to any item in the extended controls window by clicking
- Close the extended controls window
The focus should now return to the main Android emulator window, not the emulator controls, and key presses should go to Android apps.