Definition
A recessionary gap, in economics, refers to a situation where an economy’s real Gross Domestic Product (GDP) is lower than its potential GDP at full employment. This gap arises when an economy is operating below its optimal capacity, leading to a lower output and higher unemployment rates. It is often viewed as a signal of economic downturn, triggering various measures to stimulate economic growth.
Key Takeaways
- A recessionary gap, also known as a contractionary gap, refers to a state in the economy where the real Gross Domestic Product (GDP) is lower than the potential GDP. This condition signifies that the economy is not operating at its full capacity and is underperforming.
- The recessionary gap is typically characterized by high unemployment rates because firms are not producing at their maximum capacity, leading to lower demand for labor. It is one of the major indicators of an economic recession and often triggers a contractionary fiscal policy response by government.
- It is crucial to rectify recessionary gaps to return the economy back to equilibrium. Economists and policymakers typically address this through measures aimed at increasing aggregate demand, such as lowering interest rates, increasing government expenditure, or implementing tax reductions.
Importance
The finance term ‘Recessionary Gap’ is vital because it serves as an essential economic indicator that signifies the difference between the real Gross Domestic Product (GDP) and the potential GDP at full employment level.
This gap typically arises when the economy is experiencing a downturn or recession, and the level of economic output is less than its potential, leading to unemployment.
It represents underutilized resources in the economy, symbolizing a sub-optimal economic condition.
As such, the identification and analysis of a Recessionary Gap can help policy makers in determining suitable monetary or fiscal responses, such as increasing government spending or reducing interest rates, to stimulate demand, boost economic activity, and bring the economy back to its potential level.
Explanation
The Recessionary Gap is primarily used as a tool to analyze and understand the health of an economy, identifying occurrences when the overall demand for goods and services cannot sustain full employment. It happens when the total spending within an economy is lower than the total production possible at full employment, leading to a situation of excess supply or, in labor market terms, unemployment.
In situations of a recessionary gap, economists and policymakers turn their attention towards measures to stimulate economic growth and curb unemployment rates. This economic concept is beneficial in informing economic policies aimed at stabilizing the economy during periods of recession.
The Keynesian school of thought stipulates that government intervention could help a country come out of this gap. Measures such as restarting capital investment, increasing government spending, or reducing taxes, can be used to boost demand and bring the economy back to the point of equilibrium.
Thus, the presence of a recessionary gap marks a need for stimulatory policies and provides a roadmap for necessary actions to steer an economy back to full employment.
Examples of Recessionary Gap
The Global Financial Crisis of 2007-2009: This crisis caused what economists call “the Great Recession,” the most severe global recession since the Great Depression of
The unemployment rate in the US increased from
7% in November 2007 to a peak of 10% in October 2009, which is a substantial recessionary gap. Also, the GDP fell significantly during this period.
The Early 1990s Recession in the United States: After experiencing an extended period of growth in the late 80s, the U.S. fell into a recession between July 1990 and March 1991, leading to a high unemployment rate, lower output and underutilized capacity producing a substantial recessionary gap.
The Japanese ‘Lost Decade’: During the 1990s, Japan’s economy was in a recession, which led to a large recessionary gap. Despite the Japanese government’s efforts to boost the economy through the adoption of an expansionary monetary policy and increasing public investments, the high level of non-performing loans kept the income levels and the output far below the economy’s potential. This period is often referred to as the “Lost Decade,” as the economic growth was stagnant and the unemployment rate was consistently high.
FAQs on Recessionary Gap
What is a recessionary gap?
A recessionary gap, or contractionary gap, refers to a situation in an economy where the actual GDP is lower than the potential GDP at full employment. In such a gap, the economy is producing goods and services below its capability resulting in unemployment.
What causes a recessionary gap?
A recessionary gap can be caused by a decrease in aggregate demand, leading to decreased consumption, decreased investment, and decreased government spending. This decrease in demand results in decreased production and higher unemployment as companies cut back.
How can a recessionary gap be corrected?
A recessionary gap can be corrected with fiscal policy, such as increasing government spending or decreasing taxes to stimulate demand. Additionally, monetary policy, such as decreasing interest rates to stimulate investment, can also help to bring an economy out of a recessionary gap.
What is the impact of a recessionary gap on the economy?
In a recessionary gap, the unemployment rate is higher than the natural rate of unemployment. Because fewer goods and services are produced, families and businesses may experience lower income, which can result in decreased consumer confidence and reduced spending, further slowing down the economy.
How is a recessionary gap represented on an economic graph?
In an economic graph, a recessionary gap is represented by a situation where the aggregate demand curve intersects the aggregate supply curve at a level of output that is less than the full employment level of output. The difference between the full employment level of output and the current level of output represents the recessionary gap.
Related Entrepreneurship Terms
- Business Cycle
- Economic Stabilization
- Demand Deficient Unemployment
- Fiscal Policy
- Deflation
Sources for More Information
- Investopedia: This website provides a vast amount of information on various financial terms and topics, including recessionary gap.
- Khan Academy: This resource offers learning tools for a variety of subjects, including economics and finance and possibly has a detailed lesson on recessionary gap.
- Corporate Finance Institute: A professional institute dedicated to providing financial learning resources. They have many resources related to economic concepts such as the recessionary gap.
- The Library of Economics and Liberty: This free online economics library has a vast amount of resources to learn about different economic concepts, including the recessionary gap.
