A recessionary gap occurs when an economy operates below the potential equilibrium level of full employment, leading to lower GDP and prices. It is often caused by a high exchange rate and results in reduced consumer investment and high unemployment. The gap can be closed through expansionary fiscal policy.
A recessionary gap occurs when an economy operates in the short term below the potential equilibrium level of full employment. This means that the gross domestic product that is being achieved is lower than it would be at full employment, which drives prices down within the economy to reach equilibrium. The presence of a recessionary gap, also known as a contractionary gap, usually means that a recession is near, often caused by a high exchange rate reducing export income. It is usually accompanied by reduced consumer investment due to low take-home pay and high unemployment.
The full employment equilibrium is a measure of how the economy should behave if not hampered by external forces. Either outcome is possible when the actual level of gross domestic product differs from what it should be if the economy operated at full employment. If the level is above the equilibrium level of full employment, the result is an inflationary gap. A lower level indicates that a recessive gap is occurring.
The main outcome of a recessionary gap is unemployment, a social evil that makes understanding recessionary gaps so important to economists. Such gaps occur because resource prices remain relatively constant, as do workers’ wages. If a recession were to occur in the economy, the demand for resources would drop. This is when unemployment levels rise, as demand for employment and output decreases even as prices and wages remain tight.
The gaps in the economy occur due to the difference between full employment equilibrium and short-term aggregate markets. While the equilibrium is unaffected by external forces, aggregate markets represent the push and pull of supply and demand. A recession will cause the amount of gross domestic product to fall below the full employment level. For example, an economy that is producing only $10 million US dollars (USD) in gross domestic product but could produce $15 million at full employment equilibrium would have a recession gap of $5 million.
In this case, external forces often take steps in an attempt to restore equilibrium in the economy. Most often this is achieved through an increase in government spending or a reduction in taxes. If these methods are effective, the level of unemployment should decrease as the demand for more output increases, bringing aggregate markets to the equilibrium level of full employment. Collectively, these methods are known as expansionary fiscal policy, which is the most proven method available for closing the recessionary gap.
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