What is Recessionary Gap?

A recessionary gap, or contractionary gap, is a macroeconomic term where a country's real GDP is lower than it's gross domestic product (GDP) at full employment.

Key Takeaways

  • A recessionary gap, or contractionary gap, is a macroeconomic term where a country's real GDP is lower than it's gross domestic product (GDP) at full employment.
  • Recessionary gaps close when real wages return to equilibrium, where the quantity of labor demanded equals the quantity supplied.
  • Policymakers may choose to implement a stabilization policy to close the recessionary gap and increase real GDP.

Understanding Recessionary Gap

Essentially, a recessionary gap refers to the difference between actual and potential production in an economy with the actual being lower than the potential, which puts downward pressure on prices in the long run. Often, these gaps are evident during an economic downturn (recession) and are associated with higher unemployment numbers.

Significant reductions in economic activity for several months will indicate a recession. During periods of recession, companies will often pull back on spending creating a gap from the contraction in the business cycle. Economists define a recessionary gap as a lower, real-income level, as measured by real GDP than the real-income level at a point of full employment. Real GDP values all goods and services for a specific time-frame and adjusts that for inflation. In the period leading up to a recession, there is often a significant reduction in consumer expenditure or investment due to a decrease in the take-home pay of workers.

Recessionary Gaps and Exchange Rates

When production levels fluctuate, prices change to compensate. This price change is considered an early indicator that an economy is moving into a recession and may lead to less favorable exchange rates for foreign currencies. An exchange rate is merely one country's currency in comparison with that of another country. At parity, the two currencies exchange one for one. However, countries might adopt monetary policies to lower rates in an effort to encourage foreign investment or raise rates to encourage internal consumption of homemade products. The change in exchange rates affects the financial returns on exported goods. Lower foreign exchange rates mean less income for exporting countries' and further drives a recessionary trend.

Offsetting Recessionary Gaps

Although it represents a downward economic trend, a recessionary gap can remain stable suggesting short-term economic equilibrium below the ideal, which can be as damaging to an economy as an unstable period. This instability is because prolonged downward periods of lower GDP production inhibit growth and contribute to sustained higher unemployment levels.

Also, policymakers may choose to implement a stabilization policy (expansionary policy) to close the gap and increase real GDP. Monetary authorities may increase the amount of money in circulation in the economy by lowering interest rates and increasing government spending.

The Recessionary Gap and Unemployment

A more important outcome of a recessionary gap is increased unemployment. During an economic downturn, the demand for goods and services lowers as unemployment rises. If prices and wages remain unchanged, this can further elevate unemployment levels. In a cycle which feeds upon itself, higher unemployment levels reduce overall consumer demand, which reduces production, and lowers the realized GDP. As the amount of output continues to fall, fewer employees are required to meet production demand resulting in additional job losses and further reducing the need for goods and services.

As a company's profits stagnate or decline, the company cannot offer higher wages. Some industries may experience pay cuts due to internal businesses practices, or the effect of economic circumstances. For example, during a recession, people spend less on going out to eat, which means that restaurant workers receive less income in the form of tips.

Recessionary Gap Example

In December 2018, the U.S. labor market as a whole was at full employment with an unemployment rate of 3.7% and there was no recessionary gap. However, not all parts of the country were at full employment, and some individual states were experiencing a recessionary gap. For example, New York was at full employment, and most large cities were economically secure.

However, the picture was very different in rural areas where jobs were more difficult to find. In West Virginia, for example, the decimated coal mining industry brought the unemployment rate to 5.3% with little economic productivity. Additionally, West Virginia was one of four states with a poverty rate above 18%.