A recessionary gap occurs when an economy is operating in the short term at a level below the potential full-employment equilibrium level. This means that the gross domestic product being achieved is lower than it would be at the level of full employment, which causes prices within the economy to drop to achieve balance. 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 that reduces income from exports. It’s usually accompanied by reduced consumer investments due to poor take-home pay and high unemployment.
Full-employment equilibrium is a measure of how the economy should behave if unencumbered by outside forces. One of two outcomes is possible when the actual level of gross domestic product differs from what it should be if the economy were operating at full employment. If the level is higher than the full-employment equilibrium level, then an inflationary gap is the result. A lower level means that a recessionary gap is occurring.
The main outcome of a recessionary gap is unemployment, a societal ill that makes understanding recessionary gaps so important to economists. Such gaps occur because the prices of resources remain relatively constant, as do workers’ wages. Should a downturn in the economy occur, then the demand for resources would drop. This is when unemployment levels rise, since the demand for employment and production drops even as prices and wages stay rigid.
Gaps in the economy occur as the result of the difference between full-employment equilibrium and the short-run aggregate markets. Whereas the equilibrium is unaffected by outside forces, the aggregate markets represent the push and pull of supply and demand. A recession will cause the amount of gross domestic product to drop below the full-employment level. For example, an economy which is producing only $10 million US Dollars (USD) in gross domestic product but could be producing $15 million USD at full-employment equilibrium would have a recessionary gap of 5 million USD.
When this occurs, steps are often taken by outside forces in an attempt to once again achieve balance in the economy. Most often this is achieved via an increase in government spending or a reduction in taxes. If these methods are effective, then the unemployment level should decrease as demand for more production rises, raising the aggregate markets to the level of full-employment equilibrium. These methods as a whole are known as expansionary fiscal policy, which is the most proven method available for closing the recessionary gap.