Recessionary Gap
What is Recessionary Gap?
A recessionary gap is the difference between full-employment real GDP and actual real GDP when actual is less than full employment.
A recessionary gap occurs when an economy is producing less than its potential, leading to higher unemployment. This typically happens during a contraction in the business cycle. The gap represents the amount by which real GDP falls short of potential GDP.
Recessionary Gap: a worked example
Suppose full-employment real GDP is $900 billion and actual real GDP is $855 billion. The recessionary gap equals $900 billion minus $855 billion, or $45 billion, which is 45 ÷ 900 = 5 percent of potential output. To close it with fiscal policy, first find the multiplier. If the MPC is 0.75, the spending multiplier is 1 ÷ (1 - 0.75) = 4, so government purchases need to rise by $45 billion ÷ 4 = $11.25 billion. A tax cut works through a smaller multiplier, MPC ÷ MPS = 0.75 ÷ 0.25 = 3, so taxes must fall by $45 billion ÷ 3 = $15 billion to move spending the same distance. Either policy shifts aggregate demand right by $45 billion at the current price level and returns output to $900 billion.
The mistake students make with recessionary gap
The costly error is setting the spending increase equal to the size of the gap itself. A $45 billion gap tempts students to write in $45 billion of new government purchases, because both figures are measured in dollars of output. The gap is the required shift in aggregate demand, not the required injection. Divide by the multiplier first: with an MPC of 0.75 the multiplier is 4, so $11.25 billion does the job. The mirror error is multiplying instead, which gives $180 billion. Any answer larger than the gap has the operation backwards, since the multiplier exists to let a small injection do a big job.
Recessionary Gap questions
How do you calculate a recessionary gap?
Subtract actual real GDP from full-employment real GDP. If potential output is $900 billion and the economy produces $855 billion, the recessionary gap is $45 billion. Questions often want the gap as a share of potential output as well, which here is 45 ÷ 900, or 5 percent. The gap measures a shortfall, so report it as a positive dollar amount whenever actual output falls short of potential.
Does a recessionary gap mean the economy is shrinking?
No. A recessionary gap describes where output sits relative to full employment, not which direction output is moving. An economy can grow at 2 percent a year and still produce below potential, which keeps the unemployment rate above the natural rate. The gap closes only when actual output catches up to potential, either through self correction as nominal wages fall or through expansionary fiscal or monetary policy.
What does a recessionary gap look like on an AD-AS graph?
Short-run equilibrium, where aggregate demand crosses short-run aggregate supply, lies to the left of the vertical long-run aggregate supply curve. The horizontal distance between that equilibrium output and the LRAS line is the recessionary gap. Label both output levels on the horizontal axis, mark the distance between them, and expect unemployment above the natural rate at that point.
This is the live AD/AS Model sandbox. Drag the curves, or open the full version.
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