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Recessionary Gap

Updated on January 31, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is Recessionary Gap?

Recessionary Gap Definition – It can be defined as the difference between the real GDP and potential GDP at the full employment level. This is also known as the contractionary gap. Real GDP is always outweighed by potential GDP because the economy’s aggregate output is always lower than the aggregate output that would be obtained at full employment.

In simpler words, we can say that this is the gap between actual production and the full employment output when the actual output is lower than the natural output level.

In simpler words, we can say the this is the gap between actual production and the full employment output when the actual output is leer than the natural level of output.

Recessionary Gap

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The below recessionary gap graph depicts this situation. It is the economic situation when the real GDPReal GDPReal GDP can be described as an inflation-adjusted measure that reflects the value of services and goods produced in a single year by an economy, expressed in the prices of the base year, and is also known as "constant dollar GDP" or "inflation corrected GDP."read moreis lower than the natural GDP. As shown in the chart below, the economy faces a recessionary gap when the real output is lower than expected. As shown in the figure below, the aggregate demandAggregate DemandAggregate Demand is the overall demand for all the goods and the services in a country and is expressed as the total amount of money which is exchanged for such goods and services. It is a relationship between all the things which are bought within the country with their prices.read more and SRAS (short-run aggregate supplyAggregate SupplyAggregate Supply is the projected supply that a business calculates based on the existing market conditions. Various factors such as changing economic trend are considered before calculating the aggregate supply.read more) intersect at a point left of the LRAS (long-run aggregate supply).

Recessionary Gap - Graph

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  • LRAS- Long-run aggregate supply
  • SRAS- Short-run aggregate supply

Key Takeaways

  1. The recession gap is characterized as the disparity between real and potential GDP at full employment. The contractionary gap is another name for this.
  2. It primarily occurs due to inefficient resource allocation, which causes an economic slowdown because businesses in this situation are making less money. 
  3. Monetary policy is executed by lowering interest rates in the economy to increase the amount of money available and promote growth. 
  4. Demand for goods and services declines when unemployment increases during an economic crisis. Unemployment rates will rise if prices and salaries remain the same in this scenario.

Explanation of Recessionary Gap

When a recession happens when the economy is not reaching its full potential, there comes the recessionary gap. It measures the difference between where the economy is and where it should be. The ideal situation will prevail when the economy is in long-run equilibrium where all the resources are utilized to their maximum and most efficient capacity. It should be kept in mind that the ideal economy does not mean zero unemployment, factories running twenty-four hours seven days a week. In such a situation, the natural unemploymentNatural UnemploymentNatural unemployment or natural rate of unemployment refers to the portion of unemployment in a healthy economy. read more rate shall be there, including unemployed individuals because they are in transition. Also, the factories will have their downtime for maintenance and upgrading.

This is pointed out that the economy is operating below the full-employment level, thereby leading to a downfall of the general price level in the long term. It comes into the forefront during times of economic downturn and is related to higher unemployment numbers.

Although it implies an economic downturn, it can remain stable, suggesting short-term economic equilibrium below the ideal, which may damage an economy as an irregular period. This happens because long periods of lower GDP production inhibit growth and contribute to sustained higher unemployment levels. Moreover, since production levels change to compensate for it, the prices also vary.

This is a sign that the economy is moving into a recession, leading to unfavorable exchange rates for foreign currencies. When the exchange rate for foreign currencies is affected, it also affects the financial returns on the exported goods. Therefore, the lower return on exported goods contributes less towards the exporting countries’ GDP and further catalysts to the recessionary trend.

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Recessionary Gap Explained in Video

 

Causes of Recessionary Gap

  • This mainly happens due to inefficient allocation of resources, thus resulting in a downturn in the economy as in this situation, the firms have lower profits. They are bound to lay off more workers. This leads to an increase in unemployment, thus decreasing consumer spending and the aggregate demand.
  • In the long run, a recessionary gap relates to a business cycle contraction.
  • In short, the causes of the creation of this gap is decreased in the spending by the government, increase in the population that requires more resources to sustain itself, increase in the tax rate by the government that affects the demand level due to decrease in the supply of money in the economy and fluctuation in the prices again resulting in the decrease of consumption and demand.

Effects of Recessionary Gap

The effects of this gap increase the unemployment level in the economy, as the economy is creating lesser than the natural GDP growth level. It also results in lower production and lower economic growth. There is the business cycleBusiness CycleThe business cycle refers to the alternating phases of economic growth and decline.read more contraction due to the lower level of demand and lesser supply of money in the overall economy.

Solution to Recessionary Gap Problem

To find a solution to the recessionary gap the governments implement expansionary monetary policy and fiscal policy. Monetary policyMonetary PolicyMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more is implemented by reducing the interest rates in the economy to increase the supply of money to enhance growth. The fiscal policy is implemented by reducing taxes and increasing government spending to boost demand.

Correlation Between Recessionary Gap and Unemployment

It must be noted that the effect of the recessionary gap is increasing unemployment. When the economy is in a downturn phase, the demand for goods and services decreases as unemployment rises. In this situation, if there is no change in price and wages, then unemployment levels are increased. The higher the unemployment levels, the lower the overall demand, which lowers necessary production and further lowers the realized GDP. With the fall in production, few employees are needed to meet production demands, thus leading to additional job losses.

In a situation where the company profits are at a standstill or are falling, a company cannot offer higher wages. In many industries, pay cuts are given in these situations. This happens due to a change in internal business practices or precise cuts, resulting from the effect on industries where a portion of the worker wages is based on tips like restaurants.

Conclusion

To conclude, we can say that the main cause of the recessionary gap is high price levels that result in lower consumption and overall demand. The effect of it is the creation of cyclic unemploymentCyclic UnemploymentCyclical unemployment is one of the types of unemployment, which usually happens during the contraction phase of the business cycle where the unemployment rate starts rising as businesses start laying off its employees during the recession period & unemployment rate decreases during the expansionary phase of the business cycle.read more in the economy. The increase in government spending and implementing policies to increase the supply of money to boost demand is the solution to the problem.

Frequently Asked Questions (FAQs)

What distinguishes a recessionary gap from an inflationary gap?

The economy experiences a recessionary gap when the short-run aggregate supply and demand curves cross below potential output. The economy experiences an inflationary gap when they exceed the potential output level.

How does expansionary fiscal policy fill the hole left by a recession?

By altering aggregate expenditures and reshaping the aggregate demand curve, expansionary fiscal policy aims to close a recessionary gap. A recessionary gap is closed with a rightward shift of the aggregate demand curve.

How can fiscal policy halt a downturn?

When a recession looks imminent, the central bank adopts an expansionary monetary policy to boost the money supply, expand the loan market, lower interest rates, and move aggregate demand to the right.

This has been a guide to what recessionary gap? Here we discuss the causes of the recessionary gap, the effects of the recessionary gap, and solutions to this problem. You can learn more about economics from the following article –

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