Recessionary Gap

A recessionary gap, or contractionary gap, is a macroeconomic term used when a country’s real gross domestic product (GDP) is lower than its GDP at full employment.

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 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, adjusted 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.

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. 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.

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.

Policymakers may choose to implement a stabilization policy (expansionary policy) to close the gap and increase real GDP.

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