Recessionary Gap

What is a 'Recessionary Gap'

A recessionary gap is a term routed in macroeconomic theory that summarizes the situation where an economy is operating at below its full-employment equilibrium. Under this condition, the level of real gross domestic product (GDP) is currently lower than it is at full employment, which puts downward pressure on prices in the long run.

BREAKING DOWN 'Recessionary Gap'

A recessionary gap happens when an economy is falling into a recession, which is defined as a lower real level of income, as measured by real GDP, then the full-employment level. An economic recession can happen in a number of ways, including a higher nominal exchange rate, which reduces net exports and domestic income, and a large reduction in consumer expenditure or investment due to a decrease in take-home pay by workers.

Also known as a contractionary gap, the recessionary gap accounts for the difference between a country’s potential GDP at full employment to the current employment level being experienced within the economy. Often, these gaps are felt during times of economic downturn and are associated with higher unemployment numbers.

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

As a result of changing production levels, prices change to compensate. This can be seen as an early indicator an economy is moving into a recession and may lead to less favorable exchange rates for foreign currencies. This change in exchange rates affects the financial returns on goods sent out as exports. The lower return produces less for the exporting countries' GDP, and further drives the recessionary trend.

Recessionary Gap and Unemployment

A more notable 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. Higher unemployment levels result in lower overall demand, which lowers necessary production and further lowers the realized GDP. As the amount of production continues to lower, fewer employees are required to meet production demands, resulting in more positions being cut.

As company profits stagnate or fall, a company is not in the position to offer higher wages. In fact, some industries may experience pay cuts. This can be due to a change in internal businesses practices or circumstantial cuts resulting from the effect on industries where a portion of worker wages are supported by tips, such as restaurants.