How to Close a Recessionary or Inflationary Gap

A recessionary gap exists when real GDP is below full-employment (potential) output, so short-run equilibrium sits to the left of the long-run aggregate supply (LRAS) curve and unemployment is above the natural rate. An inflationary gap is the opposite: real GDP is above potential, equilibrium sits to the right of LRAS, and unemployment is below the natural rate. Expansionary policy closes a recessionary gap, contractionary policy closes an inflationary gap, and without any policy both gaps eventually close on their own as nominal wages adjust.

See it move

Make it move

The AD-AS model in long-run equilibrium at full-employment output. Tap it to drag the curves, open the full version, or put it on your own site free, or turn it into a five-minute class activity.

This guide covers how to spot each gap on the AD-AS graph, how to measure it, what it means for unemployment, which policy closes it, and how big that policy needs to be. For a quick side-by-side of the two definitions, see the recessionary gap vs inflationary gap comparison.

Reading a gap off the AD-AS graph

Every output gap question uses the same three curves:

• Aggregate demand (AD) slopes downward.
• Short-run aggregate supply (SRAS) slopes upward because nominal wages and some input prices are sticky in the short run.
• Long-run aggregate supply (LRAS) is vertical at full-employment output, often labeled Yf or Y*.

The economy's current position is the short-run equilibrium, where AD crosses SRAS. To classify it, look only at where that intersection sits relative to LRAS:

• Intersection left of LRAS: real GDP is below potential, a recessionary gap.
• Intersection right of LRAS: real GDP is above potential, an inflationary gap.
• Intersection on LRAS: the economy is at full employment and there is no gap.

The price level does not tell you which gap you are in. A recessionary gap caused by a fall in AD comes with a lower price level, but a recessionary gap caused by a leftward SRAS shift (a supply shock such as a jump in oil prices) comes with a higher price level. That second case is stagflation. Always classify by output, never by prices. If the difference between the two supply curves is fuzzy, read SRAS vs LRAS first.

You can build both gaps yourself on the interactive AD-AS graph: shift AD left or right from long-run equilibrium and watch the intersection move off the LRAS line.

The two gaps side by side

What each gap means for unemployment

Output and employment move together. When firms produce less than potential output, they need fewer workers, so the unemployment rate rises above the natural rate of unemployment. The extra unemployment beyond the natural rate is cyclical unemployment. When firms produce more than potential, they hire aggressively, pay overtime, and pull in workers who would normally be between jobs, so the unemployment rate falls below the natural rate.

A hypothetical example: suppose the natural rate is 4.5 percent.

• If actual unemployment is 7 percent, cyclical unemployment is 7 minus 4.5 = 2.5 percentage points, and the economy is in a recessionary gap.
• If actual unemployment is 3.5 percent, the actual rate is 1 percentage point below the natural rate, so cyclical unemployment is negative, and the economy is in an inflationary gap.

The same story appears on the Phillips curve. A recessionary gap puts the economy to the right of the vertical long-run Phillips curve (unemployment above the natural rate). When the gap comes from a fall in AD, that is a movement down the short-run Phillips curve to lower inflation. When it comes from a supply shock, the short-run Phillips curve shifts right and inflation rises instead. An inflationary gap caused by rising AD puts the economy to the left of the long-run Phillips curve (low unemployment, higher inflation). The Phillips curve guide shows how the two graphs line up.

How to measure the size of a gap

The gap is the distance between actual real GDP and potential real GDP on the horizontal axis.

• Recessionary gap = potential real GDP minus actual real GDP
• Inflationary gap = actual real GDP minus potential real GDP
• Gap as a percent of potential = (gap / potential real GDP) x 100

Divide by potential output, not actual output, when you convert to a percent. The recessionary gap calculator and the inflationary gap calculator walk through both versions.

Closing each gap with policy

Policymakers close a gap by shifting AD back toward LRAS.

To close a recessionary gap, shift AD to the right with expansionary policy:

• Expansionary fiscal policy: increase government spending, cut taxes, or raise transfer payments.
• Expansionary monetary policy: the central bank buys government bonds or lowers its policy interest rate, which lowers interest rates and raises investment and consumer spending.

To close an inflationary gap, shift AD to the left with contractionary policy:

• Contractionary fiscal policy: cut government spending, raise taxes, or reduce transfer payments.
• Contractionary monetary policy: the central bank sells government bonds or raises its policy interest rate.

When expansionary policy closes a recessionary gap that began with a fall in AD, the price level rises from its short-run level and ends near where it was before the downturn. When contractionary policy closes an inflationary gap, the price level falls from its short-run level, so it ends lower than it would have without the policy. The full chain of fiscal tools lives on the AP Macro fiscal policy topic page.

Worked example: sizing the policy

This is where the multiplier earns its place. The logic is simple: the change in real GDP equals the multiplier times the change in spending, so the spending change you need equals the gap divided by the multiplier. The multiplier effect guide explains where the formulas come from; here we just apply them. All numbers below are hypothetical.

Case 1: a recessionary gap. Potential real GDP is $2,000 billion. Actual real GDP is $1,900 billion. The marginal propensity to consume (MPC) is 0.8.

1. Size the gap: 2,000 minus 1,900 = $100 billion. As a percent of potential, 100 / 2,000 x 100 = 5 percent.

2. Spending multiplier = 1 / (1 - MPC) = 1 / 0.2 = 5.

3. Required increase in government spending = 100 / 5 = $20 billion.

4. Tax multiplier = -MPC / (1 - MPC) = -0.8 / 0.2 = -4.

5. Required change in taxes = 100 / -4 = -$25 billion, a $25 billion tax cut.

Check: 5 x 20 = 100, and -4 x -25 = 100. Both close the gap exactly. The tax cut has to be larger than the spending increase because households save part of a tax cut before it is ever spent.

Case 2: an inflationary gap. Potential real GDP is $2,000 billion. Actual real GDP is $2,080 billion. The MPC is 0.75.

1. Size the gap: 2,080 minus 2,000 = $80 billion, or 80 / 2,000 x 100 = 4 percent of potential.

2. Spending multiplier = 1 / 0.25 = 4.

3. Required cut in government spending = 80 / 4 = $20 billion.

4. Tax multiplier = -0.75 / 0.25 = -3.

5. Required tax increase = 80 / 3 = about $26.7 billion.

Check: -3 x 26.7 is about -80, which pulls output down to potential. You can rerun these with your own numbers on the required spending change calculator and the required tax change calculator.

Closing the gap with no policy at all

If the government and central bank do nothing, the economy still returns to potential output in the long run, because nominal wages respond to the labor market.

• Recessionary gap: unemployment is above the natural rate, so nominal wages fall over time. Lower costs shift SRAS to the right. The price level falls and real GDP rises until SRAS crosses AD on the LRAS line.
• Inflationary gap: unemployment is below the natural rate, so nominal wages rise. Higher costs shift SRAS to the left. The price level rises and real GDP falls until the economy is back on LRAS.

In both cases LRAS does not move and AD stays where it was. Only SRAS shifts. Because wages are sticky, especially downward, this can take a long time, which is the main argument for active policy. The full process, with a table of every stage, is in long-run self-adjustment explained.

How it shows up on the AP exam

Output gap questions usually start from a described situation (for example, unemployment above the natural rate) and ask you to carry it through several steps. Expect to:

• Draw a correctly labeled AD-AS graph showing the economy in the gap, with short-run equilibrium output and price level marked and LRAS at full-employment output.
• Identify the gap from a statement about unemployment, output, or a graph.
• Name a specific fiscal or monetary action that closes it and show the AD shift.
• Calculate the gap and the minimum spending or tax change using the MPC.
• Explain what happens in the long run if no policy is used, and show the SRAS shift.

Common mistakes:

• Classifying by the price level. A recessionary gap can come with a higher price level after a supply shock. Look at output relative to LRAS.
• Multiplying instead of dividing. The gap divided by the multiplier gives the policy size. The gap times the multiplier is a huge, wrong number.
• Using the spending multiplier for a tax change. Taxes use -MPC / MPS, which is smaller in absolute value.
• Shifting LRAS. Neither policy nor wage changes move LRAS in these questions.
• Shifting AD during self-adjustment. If the question says no policy is taken, only SRAS moves.

Summary

Find the short-run equilibrium, compare it with LRAS, and you know the gap. Left of LRAS means a recessionary gap with high unemployment; right of LRAS means an inflationary gap with low unemployment. Close it with policy by shifting AD (sized with the multiplier), or wait for nominal wages to shift SRAS. Those four moves cover almost every output gap question in AP Macro Unit 3.