recessionary gap causes effects and potential solutions
Recessionary Gap: Causes, Effects, and Potential Solutions
A recessionary gap occurs when the actual GDP (gross domestic product) is lesser than the GDP at full employment. The Buzzle article below outlines the definition of a recessionary gap along with its causes, effects, and potential solutions.
- It is caused due to high price levels.
- It generally leads to cyclic unemployment.
- To eliminate a recessionary gap, government spending should be increased.
- Also known as a contractionary gap, a recessionary gap defines the difference between the GPD at full employment and the actual GDP.
- To put it simply, economic equilibrium exists when demand meets supply or the amount of labor equals the quantity supplied. In such a case, the actual GDP will meet expectations, with required raw material and full employment.
- When a recession approaches, the economy begins contracting, resources are priced high, and there is considerably lesser workforce.
- Thus, the GDP at such a time will be lesser than what it could have been, had there been a price equilibrium. This situation is defined by means of a recessionary gap―the potential difference between the actual GDP and the possible GDP.
- Mathematically, the calculation varies―firstly, as per the method used to demonstrate the concept graphically, and secondly, as per the numbers (price, wages, GDP, etc.) used in question.
- In general though, the formula can be considered as the one mentioned above.
- If the answer is negative, there is a recessionary gap.
- The concept has been outlined in the graph below.
- When the output is lower than expected, the 'AD' (aggregate demand) and 'SRAS' (short-run aggregate supply) intersect at a point to the left of the 'LRAS' (long-run aggregate supply), as shown above.
- The difference between the real GDP and the potential GDP is thus negative; this is called a recessionary gap. In such a scenario, the current unemployment rate will be more than the natural unemployment rate.
- Usually, a recessionary or inflationary gap is allowed to return to an equilibrium at its own pace. However, there are alternative solutions to improve the same.
- Closing the recessionary gap using fiscal policy or monetary policy are two of the most common solutions.
- Fiscal policies include reducing taxes, increased government spending, and increased transfer of payments.
- Monetary policies involve increase in the supply of capital and reduced rates of interest by the Federal Reserve System.
- It involves increasing the aggregate demand by means of increased government expenditure and reduced taxation.
- An expansionary policy is one of the stabilization policies employed to reduce the recessionary gap.
- Once taxes are reduced and circulation of money increases, there is increased consumption, and naturally, an increased aggregate demand.
- This change in aggregate demand is depicted in the graph below. The output achieved by the economy increases as well, thus reducing the recessionary gap.
- A nonintervention policy indicates a gradual closing of the recessionary gap. In this case, we witness a change in the short-run aggregate supply curve, as shown in the graph.
- With a natural shift in the wages (until it reaches the employment level at equilibrium), the aggregate supply curve undergoes periodic shifts. This change is allowed to continue until the output increases and the economy moves towards an equilibrium.