Recessionary Gap

Where there’s a recession, there’s a recessionary gap. Probably. Or else...it wouldn’t be much of a recession.

A recessionary gap describes the gap between actual GDP and if-we-weren’t-in-a-recession-rn GDP. The hypothetical GDP, called “potential GDP” is based on estimates, which are assuming full employment.

Usually, recessions come with layoffs, so unemployment goes up. All those unemployed people who wish they had jobs...yeah. All of their unused work hours and ethic that would be contributing value toward GDP makes up the recessionary gap.

When real GDP is lower than the level of GDP with full employment, prices go down. The people who got laid off don’t have money to spend, and the people who have jobs aren’t spending, because they’re afraid they’ll get laid off.

How do we know when the gap is no more? When we’ve got near full employment, and wages are at market equilibrium. It’s not easy bouncing back though; often, firms that survive recessions have learned to do more with less...including fewer employees. So it can be difficult to get back to full employment.

A government might choose not to intervene during a recession, or they might pull an “expansionary policy” strategy to try to boost real GDP. Boom or bust, as the Fed says. (They don’t...but they could.)