Recessionary Gap

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 aggregate output of the economy is always lower than the aggregate output that would be obtained at full employment.

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.

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Source: Recessionary Gap (wallstreetmojo.com)

The below recessionary gap graph depicts this situation. It is the economic situation when the real GDPReal GDP Real 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 more is lower than the natural GDP. The economy faces a recessionary gap when the real output is lower than expected as shown in the chart below. The aggregate demandAggregate Demand Aggregate 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 Supply Aggregate 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), as shown in the figure below.

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

Explanation of Recessionary Gap

When a recession happens when the economy is not reaching its full potential. There comes in the recessionary gap. It measures the difference between where the economy is and where the economy 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 unemployment rate shall be there which includes individuals who are unemployed because they are in transition. Also, the factories will have their downtime for maintenance and up-gradation.

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 the 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 be as damaging to an economy as an unstable period. This happens because long periods of lower GDP production inhibit growth and is the main contributor to sustained higher unemployment levels. Since production levels change to compensate it the prices also change.

This is a sign that the economy is moving into a recession and may lead 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. The lower return on exported goods contributes less towards the exporting countries’ GDP and further acts as a catalyst to the recessionary trend.

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 and 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 has a relationship with 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 in 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 contraction of the business cycleBusiness Cycle The business cycle refers to the alternating phases of economic growth and decline.read more 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 Policy Monetary 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 in order to increase the supply of money to enhance growth. The fiscal policy is implemented by the reduction of taxes and increasing government spending in order to boost demand.

Correlation Between Recessionary Gap and Unemployment

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

In a situation like this 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 circumstantial cuts which are the result of 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 for the creation of the recessionary gap is high price levels that results in lower consumption and overall demand. The effect of it is the creation of cyclic unemploymentCyclic Unemployment Cyclical 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 in order to boost demand is the solution to get rid of the problem.

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