Recessionary Gap (Definition, Graph) | Top Causes of Recessionary Gap

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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.

The below recessionary gap graph depicts this situation. It is the economic situation when the real GDP is lower than the natural GDP. The economy faces a recessionary gap when the real output is lower than the expected as shown in the chart below. The aggregate demand and SRAS (short-run aggregate supply) 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 utilised 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, 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 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 the 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 decrease in the spending by the government, increase in the population that requires more resources to sustain itself, increase in the tax rate by government that effects 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 cycle 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 and fiscal policy. Monetary policy 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 the 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 decrease 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 the 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 the lower consumption and overall demand. The effect of it is the creation of cyclic unemployment in the economy. The increase in the government spending and implementing policies to increase the supply of money in order boost demand is the solution to get rid of the problem.

Recessionary Gap