Recessionary Gap – Definition Examples Graph How To Remove

What is Recessionary Gap?

The recessionary gap is the negative gap between the actual GDP level and the potential GDP level of the economy. In other words, the recessionary gap measures the amount of actual GDP less than the potential GDP level of the economy.

AD-AS model – long-run Equilibrium

Long run equilibrium of an economy is the point where aggregate demand, short-run aggregate supply and long-run aggregate supply equal to each other. This is the full employment output level of the economy. So, there is no recessionary gap or inflationary gap. The long-run equilibrium is changed as a result of changing the long-run aggregate supply.

The above graph shows the long-run equilibrium of the AD-AS model. The economy achieves the long-run equilibrium (full employment output level) at Yf point. In this point AD, SRAS, and LRAS are equal to each other.

AD-AS model – Short-run Equilibrium

Short run equilibrium of an economy is the point where aggregate demand equals to the short-run aggregate supply. So, in the AD-AS model, you can find the short-run equilibrium by finding the point where AD intersects SRAS. This short-run equilibrium point can be changed by any factor that shifts the AD curve and SRAS curve.

So, to read more about factors shift the AD curve and SRAS curve, kindly click on “AD-AS model”.

A short-run equilibrium level can occur even though the economy is in the full employment output level, inflationary gap, or recessionary gap.

What is the formula of recessionary gap?

Simply we measure the recessionary gap by subtracting the potential GDP (full employment level GDP) from the actual GDP

Recessionary Gap Example

The US economy’s real GDP was 17.95 billion in 2005, compared to a potential GDP of 66.86 billion. There is a recessionary gap because the potential GPD is higher than the real GDP. In other words, full employment is not being reached by the American economy. This is due to the fact that the US economy’s aggregate demand (real GPD) is currently lower than its potential GDP, or the amount of output it could create if all of its resources were used.

Further, unemployment in the USA has risen in the year 2020. The unemployment rate in 2020 peaked in April at 14.8% and ended the year at 6.7%. In 2020, the GDP was $20.93 trillion. Due to the rise in unemployment, there was a sizable negative output gap that totalled $800 billion, or $21.73 trillion minus $20.93 trillion.

Recessionary Gap Graph

Using the AD-AS model, the recessionary gap can be graphed as follows.

According to the above graph, the full employment output level is shown in the Yf. The actual output level is shown in the Y1. So, the actual output level is less than the full employment output level. The gap between the actual output level and the full employment output level is called the “recessionary gap”). So, here economy does not use all the resources for the production process.

What Causes Recessionary Gap?

We can identify main two reasons for the recessionary gap. They are a decrease in aggregate demand and a decrease in aggregate supply. I will discuss them more clearly.

1. Decrease in the aggregate demand

A lower level of aggregate demand can be occurred as a result of decreasing private consumption, decreasing private investment, decreasing government expenditure, and decreasing net exports.

2. Decrease in the aggregate supply.

When nominal wages are increased and input prices are increased, economy decreases the resource usage. They will discourage the short-run aggregate supply. This can create a recessionary gap.

When short-run aggregate supply is decreased, there can be occurred a stagflation situation. Because both inflation and unemployment can be increased by the negative shocks of the aggregate supply.

How to remove recessionary gap?

To remove the recessionary gap (in other words, to expand the economy), a government can apply mainly two kinds of macroeconomic policies. They are demand-side policies and supply-side policies.

1. Demand-side economic policies

The government should use demand-side economic policies to expand the economy. For example, the government should use expansionary fiscal policy (increase government expenses and decrease government taxes) and expansionary monetary policy (increase the money supply).

As a result of these policies, the aggregate demand of the economy will shift to the right as presented in the following graph (AD curve shift to the AD1). The economy will again produce at the full employment output level (Yf).

2. Supply-side economic policies

The government also can use supply-side economic policies to expand the economy. Here government should take actions to increase the aggregate supply. For examples, the government should decrease the nominal wage rates.

As a result of these policies, the aggregate supply of the economy will shift to the right as presented in the following graph (AS curve shift to the AS1). The economy will again produce at the full employment output level (Yf).