Recessionary Gap

What is Recessionary Gap?

A recessionary gap is a macroeconomic term that is used to describe when a nation’s real Gross Domestic Product (GDP) is lower than GDP in full employment.

Now you must be wondering what is full employment, right? Well, full employment refers to an economic situation where available labour resources are not put to use in the best way possible. Note that real GDP refers to the value of goods and service for a time period adjusted for Inflation.

What Causes a Recessionary Gap?

It is a difference between the actual and potential production in a nation’s Economy that causes this gap. When the actual production is lower than the potential one, downward pressure is applied to the prices in the long-term. These gaps can be noticed when there is high unemployment in the country.

Reduction in economic activities for months together indicates Recession and during this time firms will cut down on their spending. This causes a gap to be formed in the business cycle.

When a recession is about to occur, the consumer spending reduces due to reduction in take-home salaries for employees and high unemployment.

Recessionary Gap Diagram

An economy undergoes a recessionary gap when the real output is less than the expected output. In the image, you can see that the Short-Run Aggregate Supply (SRAS) and the aggregate demand are intersecting at a point on the left of the Long-run Aggregate Supply (LRAS).

Recessionary Gap and Exchange Prices

Exchange prices are hugely impacted by changes in demand. Due to the change in the level of production, the prices try to compensate. This change in price is also an indicator that an economy is moving toward recession, which may also cause an unfavourable exchange rate for foreign currencies. In such cases, countries often adopt policies that lower rates to encourage foreign investment or raise the rate to encourage the consumption of products manufactured in the home. This change in exchange rates also impacts the returns on exported commodities.

Remember that when there is a recessionary gap, the foreign exchange rates are low, which means that the Income for the nations exporting falls. This further increases recession.

Unemployment and Recessionary Gap

Unemployment is a major product of the recessionary gap. Due to the fall in demand for commodities and services, the rate of unemployment rises. If the prices and other factors remain unchanged, unemployment levels can rise even more. When unemployment rises and consumer demand declines, the level of production reduces. This in turn reduces realised GDP. When the level of output continues to fall, few employees are retained to meet the demand in production which results in job losses and further reducing the need for more goods and services.

Note that when a business’ profits decline or become stagnant, a higher salary cannot be offered. Some industries resort to salary cuts. A recessionary gap example would be when an individual visits a restaurant for a meal. The individual may order for fewer items due to lower-income and payout lower tips to the waiter.

Recessionary Gap and Inflationary Gap

There are some key differences in the recessionary and Inflationary Gap. They are mentioned below:|