Recessionary GapExplained & Defined
A recessionary gap is a term in macroeconomics that describes the gap between an economy’s real gross domestic product (GDP) and what it would be at full employment.
A recessionary gap, also known as a contractionary gap or a negative output gap, occurs when labor resources in an economy are not being used in the most efficient way possible.
A recessionary gap is most often associated with recessions that occur as part of an economy’s business cycle.
During a recession, demand for products and, in turn, labor declines, causing decreased production and increased unemployment.
This causes a country’s GDP to fall short of its full potential creating a recessionary gap.
Recessionary Gap Explained
A recessionary gap is a difference between an economy’s actual production and its greater production potential.
This full potential is considered to be full employment, at which point everyone who wants a job has one with some allowance for those in transition, fired for cause, or are reentering the workforce after school or other regular causes.
Generally, full employment is defined by economists as being an approximately 4% unemployment rate.
When a recessionary gap occurs, it pushes general price levels down in the long term.
Recessionary gaps most often occur in an economy during periods of economic downturn, also referred to as a recession.
During the four stages of the business cycle, an economy will go through an expansion, peak, contraction, and trough.
During the period of contraction, economic activity will decline and bottom out during the trough before recovering during the recovery period.
When economic activity declines for several months, the economy is referred to as undergoing a recession.
During a recession, reduced demand in an economy causes many producers to reduce their production to avoid losses.
This means that they do not need as many workers, and in many cases, due to this, they will reduce their workforce.
This has the effect of increasing the recession because people who are seeking to work will be unemployed.
They will, in turn, spend less, which further reduces demand in the economy.
This shortfall in productivity below what it would be at a maximum sustainable level is referred to as a recessionary gap, and it is measured by economists in dollar terms by measuring the difference between real GDP in an economy below its potential.
Real GDP measures the value of all goods and services within an economy for a specific time frame while adjusting for inflation.
Often in the period preceding a recession, consumer expenditure and investment decline due to a decline in workers’ income.
Recessionary Gaps and Exchange Rates
When levels of production keep changing, prices will change to compensate.
These price changes are thought to be an early sign that the economy is entering a recession, and this could result in foreign currency exchange rates that are not as positive.
An exchange rate is a rate at which one currency can be exchanged for another currency.
When the currencies are at parity, they will exchange on a one-for-one basis.
Sometimes countries will use monetary policies to lower their exchange rate in an attempt to promote foreign investment, or they might try to raise their exchange rates so as to increase the internal consumption of their own country’s products.
A change in exchange rates will have an effect on the profit a company will make on the goods it exports.
When foreign exchange rates are lower, exporting countries don’t make as much income, which makes a recession more likely.
Counteracting Recessionary Gaps
A recessionary gap does represent a declining economic trend.
Still, it can stay stable and maintain a less-than-desirable economic equilibrium in the short term, and this can be as bad for the economy as a period of instability.
Long periods of lower GDP production can constrain growth and help bring about prolonged higher levels of unemployment.
If this happens, the government may put in place a stabilization policy in order to close the recessionary gap and increase real gross domestic product.
The government may increase its spending or lower interest rates in order to try and grow the money supply.
Unemployment
One of the biggest problems with the recessionary gap is its effect on employment.
It causes an increase in unemployment. During an economic downturn, unemployment will increase, and there will be less demand for goods and services.
Then, if wages and prices stay the same, unemployment can increase even more.
This creates a cycle in which increased unemployment decreases consumer demand, and this will lower production levels, which reduces realized GDP.
When output keeps dropping, not as many employees are needed to produce the number of goods demanded, which causes further unemployment, thus causing there to be even less demand for goods and services.
The decreasing demand causes profits to level off or decline.
So, the companies cannot increase wages. They may even need to decrease wages.
Recessionary Gap Example
A real-world example of a recessionary gap occurred in 2020 due to the COVID-19 pandemic.
In late 2019, the United States had an unemployment rate that was at 3.5%, which is close to full employment and the lowest rate of unemployment in the economy in almost 50 years.
At that point, the U.S. GDP was at $21.73 trillion.
However, due to the events of 2020, the unemployment rate had risen to a high of 14.8% during the year and had only dropped to 6.7% by the year’s close.
In 2020, the U.S. GDP was $20.93 trillion.
This left a negative gap over the previous year due to unemployment which reached a staggering sum of $800 billion.
This means that the recessionary gap can be found by taking the $21.73 trillion GDP of 2019 and subtracting the $20.93 trillion of 2020, leaving a negative gap of $800 billion.
Conclusion
A recessionary gap is a difference between the real GDP and potential GDP in an economy at full employment.
This means that a recessionary gap is a difference between actual output during a recession and what it could have been at full employment.
A recessionary gap occurs whenever an economy enters a recession and closes as it returns to full employment.
Key Takeaways
- A recessionary gap refers to a gap between an economy’s real GDP and its potential GDP.
- The size of a recessionary gap depends on several factors, including the specific economy and the causes of the recession.
- Recessionary gaps decline as economic activity returns to equilibrium and unemployment decreases.
- Governments may attempt to close a recessionary gap through expansionary monetary policies.
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University of Minnesota "22.3 Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium" Page 1 . October 18, 2022
Fullerton College "RECESSIONARY AND INFLATIONARY GAPS" Page 1 . October 18, 2022