What Is a Recessionary Gap?

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

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

What Causes a Recessionary Gap?

A recessionary gap typically occurs when an economy is approaching a recession. 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 timeframe and adjusts that total by 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.

Key Takeaways

  • A recessionary gap is a macroeconomic term which describes an economy operating at a level below its full-employment equilibrium.
  • Such gaps close when real wages return to equilibrium, where the quantity of labor demanded equals the quantity supplied.
  • When the economy has a gap, policymakers may choose to let the economy return to potential output and a natural level of employment on its own. This policy is called a nonintervention policy.
  • Alternatively, policymakers may choose to implement a stabilization policy to close the gap and increase real GDP, called expansionary policy.

Recessionary Gap and the Exchange Rate

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, some monetary policy may lower rates 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 to close the gap and increase real GDP, called expansionary policy. The monetary authority 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.

Real World Example

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

However, the picture is very different in rural areas where jobs are more difficult to find. In West Virginia, for example, the decimated coal mining industry has brought the unemployment rate to 5.3% with little economic productivity. The U.S. Bureau of Economic Analysis shows that West Virginia’s GDP shrank by 1.1% in the first quarter of 2018 and grew by 3.4% in the second quarter. West Virginia is one of four states with a poverty rate above 18%.