Recessionary Gap

Published Oct 25, 2023

Definition of Recessionary Gap

A recessionary gap refers to the difference between a country’s actual level of output and its potential level of output during a period of economic downturn or recession. It represents a gap between what an economy is capable of producing and what it is actually producing. This situation occurs when there is a shortfall in aggregate demand, leading to unemployment and underutilization of resources.

Example

Let’s consider an economy that is experiencing a recession. High levels of unemployment and reduced consumer spending are indicative of a recessionary gap. Due to the lack of demand, businesses find it difficult to sell their products or services, which leads to lower production levels. Consequently, resources such as labor and capital are left underutilized.

For instance, during the 2008 financial crisis, many economies around the world experienced a recessionary gap. The collapse of the housing market and the subsequent decline in consumer spending led to a decrease in aggregate demand. As a result, businesses had to reduce their production levels, leading to higher levels of unemployment and a significant recessionary gap.

Why Recessionary Gap Matters

Understanding the concept of a recessionary gap is crucial for policymakers and economists in order to address and mitigate the negative impacts of recessions on an economy. By identifying the existence of a recessionary gap, policymakers can implement strategies and measures to increase aggregate demand and stimulate economic growth.

Governments often utilize fiscal and monetary policies to counter the effects of a recessionary gap. They may increase government spending, lower taxes, or pursue expansionary monetary policies such as cutting interest rates to encourage borrowing and investment. These actions aim to boost aggregate demand and stimulate economic activity, ultimately closing the recessionary gap.