The Concept of a Recessionary Gap
A recessionary gap, also known as a contractionary gap, occurs when a country’s real gross domestic product (GDP) is below its GDP at full employment.
Key Insights
- A recessionary gap is defined by a lower real GDP compared to full-employment GDP.
- These gaps usually close when real wages reach equilibrium, balancing labor supply and demand.
- Policymakers might implement stabilization policies to address this gap and boost real GDP.
Deciphering a Recessionary Gap
Simply put, a recessionary gap is the disparity between actual and potential economic production, where the actual falls short of its potential. This scenario indicates downward pressure on prices over time. Such gaps often appear during economic slowdowns and are linked to higher unemployment rates.
Periods of economic dips indicated by marked reductions in activity span several months point towards a recession. Businesses typically slash spending, resulting in a gap from the contraction in the business cycle, aligning with poorer economic performance.
Economists identify a recessionary gap as a condition where the real-income level measured by real GDP is lower than the real-income level at full employment. Real GDP, adjusted for inflation, assesses all goods and services for a specified period. A recession often starts with dwindling consumer spending or investment due to reduced take-home pay.
Recessionary Gaps and Fluctuating Exchange Rates
Production levels directly impact prices, with price changes acting as early indicators for impending recessionary phases. These can result in less favorable exchange rates for other currencies.
An exchange rate denotes the value of one country’s currency relative to another. Countries might adopt varying monetary policies to modify exchange rates—such fluctuations can affect financial returns on exported goods. Lower foreign exchange rates can diminish income for exporting nations, intensifying a recession.
Combating Recessionary Gaps
A recessionary gap indicates downward economic momentum but can also show temporary economic stability. However, such stability can be misleadingly harmful, perpetuating lower GDP production and elevated unemployment. Policymakers may intervene with expansionary or stabilization measures to boost real GDP.
Strategies might include increasing the money supply through lowered interest rates, or boosting government spending to stimulate the economy.
Unemployment and the Recessionary Gap
One of the most concerning outcomes of a recessionary gap is the uptick in unemployment. During downturns, lowered demand for goods and services correlates with rising unemployment. Static wages and prices can aggravate this situation.
This feedback loop where decreasing demand leads to reduced production and higher unemployment continually depresses GDP, worsening the economic landscape. Workers endure wage stagnation or cuts as declining company profits constrain businesses’ ability to offer higher pay, further driving reduced spending.
Real-World Example of a Recessionary Gap
In December 2018, the U.S. labor market was thriving with an unemployment rate of 3.7%, indicating no recessionary gap nationwide. However, regional disparities existed, such as in West Virginia where the decimated coal industry saw unemployment rates at 5.3%, and higher-than-average poverty rates exceeding 18%.
Large urban centers like those in New York thrived economically, while rural areas faced significant challenges, illustrating the variability of economic health within a country.
Related Terms: real GDP, full employment, inflation, monetary policy, business cycle.
