What Is a Recessionary Gap?
Let me explain what a recessionary gap is. It's a macroeconomic term that describes when a country's real gross domestic product (GDP) is lower than what it would be at full employment. You might also hear it called a contractionary gap.
Key Takeaways
- A recessionary gap, or contractionary gap, occurs when a country's real GDP is lower than its GDP at full employment.
- Recessionary gaps close when real wages return to equilibrium, and the quantity of labor demanded equals the quantity supplied.
- Policymakers may choose to implement a stabilization policy to close the recessionary gap and increase real GDP.
Understanding a Recessionary Gap
Essentially, I'm talking about the difference between actual and potential production in an economy, where the actual output is lower than the potential. This puts downward pressure on prices over the long run. You'll often see these gaps during economic downturns, and they're linked to higher unemployment numbers.
When there's a significant reduction in economic activity for several months, it signals a recession. During these times, companies cut back on spending, which creates a gap in the business cycle due to contraction.
Economists define this gap as a lower real-income level, measured by real GDP, compared to the level at full employment. Real GDP accounts for all goods and services in a specific period, adjusted for inflation. Leading up to a recession, you typically see a big drop in consumer spending or investment because workers' take-home pay decreases.
Recessionary Gaps and Exchange Rates
When production levels change, prices adjust to compensate. This price shift is an early sign that the economy is heading into a recession and can lead to less favorable exchange rates for foreign currencies.
An exchange rate is simply one country's currency compared to another's. At parity, they exchange one for one.
Countries might use monetary policies to lower rates and attract foreign investment or raise rates to boost consumption of domestic products. Changes in exchange rates impact returns on exported goods. Lower foreign exchange rates mean less income for exporters, which drives the recessionary trend further.
Offsetting Recessionary Gaps
Even though it signals a downward trend, a recessionary gap can stay stable, indicating a short-term equilibrium below the ideal level. This can be just as harmful as instability because prolonged periods of lower GDP hinder growth and lead to sustained high unemployment.
To address this, policymakers might implement an expansionary policy—a type of stabilization policy—to close the gap and boost real GDP. Monetary authorities could increase money in circulation by lowering interest rates and increasing government spending.
The Recessionary Gap and Unemployment
One of the most critical effects of a recessionary gap is increased unemployment. In a downturn, demand for goods and services drops as unemployment rises. If prices and wages don't adjust, this can make unemployment even worse.
This creates a self-feeding cycle: higher unemployment reduces consumer demand, which lowers production and realized GDP. As output falls, fewer workers are needed, leading to more job losses and further reduced demand for goods and services.
When company profits stagnate or decline, they can't offer higher wages. Some industries might see pay cuts due to business practices or economic conditions. For example, during a recession, people eat out less, so restaurant workers get fewer tips.
Recessionary Gap Example
Take December 2018 as an example. The U.S. labor market overall was at full employment with a 3.9% unemployment rate, and there was no national recessionary gap. But not every part of the country was in the same boat—some states had recessionary gaps.
For instance, New York was at full employment, and most big cities were doing well economically. However, rural areas struggled with job availability. In West Virginia, the coal mining industry's decline pushed the unemployment rate to 5.3% with low economic productivity. Plus, West Virginia had the fourth-highest poverty rate at around 18%.
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