Definition: A recessionary gap, also known as a contractionary gap, is the difference between the real GDP and the potential GPD. The potential GDP outweighs the real GDP because the aggregate output of the economy is less than the aggregate output that would be produced at full employment.
What Does Recessionary Gap Mean?
What is the definition of recessionary gap? An RG indicates that the economy operates below the full-employment level, thus pushing the general price level down in the long-term. The main reason for this gap is the inefficient resource allocation that causes price rigidity in the short-term. Especially, wages tend to be inefficiently allocated, thus causing a downturn in the economy as firms have lower profits and are forced to lay off more workers.
As a result, unemployment increases, thus decreasing consumer spending and the aggregate demand. In the long run, a recessionary gap is related to a business-cycle contraction. To fight this gap, governments impose an expansionary monetary policy to lower taxation, stimulate economic activity, and decrease unemployment.
Let’s look at an example.
In 2005, the US economy had a potential GDP of 66.86 billion, whereas its real GDP was 17.95 billion. Since the potential GPD is greater than the real GDP, there is a recessionary gap. In other words, the US economy operates below its full-employment level. This happens because currently in the US economy the aggregate demand (real GPD) is lower than the potential GDP, i.e. the output that the US economy would produce if it employed all its resources.
To anticipate the recessionary gap, the Federal Reserve should consider stabilization policies and corrective measures. The implementation of an expansionary monetary policy would increase government spending and lower taxes. Such measures would increase consumer spending and boost economic activity, bringing the short-term output to the full-employment level, thus eliminating the gap.
Define Recessionary Gap: RG is an economic occurrence when the potential GDP or a country is greater than the real GDP.