Recessionary Gap
A recessionary gap is the difference between the level of output that an economy would produce at full employment and the lower level of output that it actually produces when aggregate demand is insufficient. It represents the shortfall in demand relative to the economy's productive capacity, and it is associated with unemployment above the natural rate, downward pressure on prices and wages, and unused capacity in the form of idle plant and equipment. Closing the gap requires measures that raise aggregate demand.
Definition
The recessionary gap is measured as the difference between potential output, the level that can be sustained at full employment with stable inflation, and actual output. When actual output is below potential, the economy has spare capacity, and the gap is positive. The gap can be expressed in absolute terms or as a percentage of potential output, and estimates of potential output are based on the productive capacity of the economy and on the sustainable rate of growth of the labour force and of productivity.
Estimates of the gap are uncertain because potential output is not directly observable. Statistical methods, including filters and production function approaches, are used to estimate potential output, and the resulting estimates are subject to revision as new data arrive. The uncertainty matters for policy, since the assessment of whether the economy has a gap influences the appropriate stance of monetary and fiscal policy.
Causes
A recessionary gap arises from a shortfall in aggregate demand, relative to the level that would be needed to employ all resources. The shortfall may result from a fall in consumption, from a decline in investment, from a reduction in government spending, or from a fall in exports. It may also result from an increase in saving, or from a shock that raises uncertainty and leads households and firms to postpone spending.
The shortfall can be triggered by various events. Financial crises reduce the availability of credit and raise uncertainty, leading to cuts in spending. Changes in the terms of trade affect incomes and demand. Fiscal consolidation, including tax increases and spending cuts, reduces demand. A loss of confidence, whether from political or economic developments, can reduce spending and investment, deepening the shortfall.
Consequences
The consequences of a recessionary gap include unemployment above the natural rate, which imposes costs on those affected and reduces the economy's output. The gap also puts downward pressure on prices and wages, which can lead to disinflation or deflation, and it reduces investment, which may have long-run consequences if it slows the accumulation of capital and reduces potential output. Prolonged gaps can lead to hysteresis, in which the natural rate rises and potential output falls.
The gap also affects the public finances. Lower output reduces tax revenue and raises spending on unemployment benefits and other transfers, widening the fiscal deficit. The increase in the deficit is partly automatic, reflecting the operation of the stabilisers, and it should be distinguished from a discretionary change in fiscal policy. The deterioration in the fiscal position can constrain policy, particularly if the government faces limits on its borrowing.
Policy responses
Closing a recessionary gap requires measures that raise aggregate demand, and both monetary and fiscal policy can be used. Monetary policy can lower interest rates, reducing the cost of borrowing and raising spending, but its effectiveness is limited when rates are near their lower bound. Fiscal policy can raise spending or cut taxes, directly adding to demand, and it is most effective when the gap is large and when monetary policy is accommodative.
The choice between the instruments depends on the circumstances, on the size of the gap, and on the constraints on policy. Structural measures, including policies that improve the functioning of the labour market and that raise potential output, can complement demand management, and they address hysteresis by preventing the erosion of skills and capital. The objective is to close the gap without generating inflation, and to ensure that the recovery is sustained.
Measurement and uncertainty
Estimating the recessionary gap requires estimating potential output, which is not directly observable. Statistical methods, including the Hodrick-Prescott filter and other smoothing techniques, extract a trend from the data, while production function approaches estimate potential output from the capital stock, the labour force, and productivity. Each method has advantages and limitations, and the estimates can differ substantially.
The uncertainty in the estimates has important implications for policy. If the gap is overestimated, policy may be too expansionary, generating inflation; if it is underestimated, policy may be too contractionary, leaving unemployment unnecessarily high. The uncertainty is greatest around turning points, when the economy is changing direction, and it is a major challenge for the conduct of stabilisation policy. Analysts therefore use a range of estimates and monitor a variety of indicators.
Interaction with hysteresis
The persistence of a recessionary gap can have lasting effects through hysteresis. Prolonged unemployment erodes the skills of workers and reduces their attachment to the labour market, while low investment slows the accumulation of capital and reduces potential output. Through these channels, a deep or prolonged recession can reduce the level of potential output, so that the gap closes partly through a decline in productive capacity rather than through a recovery in demand.
Hysteresis has important policy implications. It implies that prompt action to close the gap can prevent permanent damage, and that the cost of inaction is higher than a simple measure of the output lost during the recession would suggest. It also implies that the assessment of potential output must consider the effects of the recession itself, rather than treating potential output as independent of the path of demand, and it underlines the importance of measures that preserve skills and capital.
Policy design
The design of policy to close a recessionary gap depends on its causes and on the constraints on policy. Where the gap arises from a shock to demand, monetary policy is the first instrument, and it is supplemented by fiscal policy when rates are near their lower bound. Where the gap arises from financial disruption, measures to restore the flow of credit may be needed alongside demand management, since the usual channels of transmission may be impaired.
The composition of fiscal measures matters for their effectiveness. Spending on goods and services, particularly with domestic content, has larger effects than transfers that may be saved, and targeting households with high propensities to consume raises the multiplier. The measures should be timely, targeted, and temporary, to provide support when it is needed while avoiding a permanent deterioration in the fiscal position. The design must also consider the effects on the supply side, avoiding measures that damage the productive capacity of the economy.
International dimensions
In an open economy, the effects of policies to close a recessionary gap depend on the responses of trade and capital flows. An expansion raises imports, which benefits trading partners, so that part of the stimulus leaks abroad. Exchange rate movements can offset or amplify the effects, and the responses of other countries to their own recessions affect the demand for a country's exports.
Coordination among countries can increase the effectiveness of fiscal policy, because the spillovers mean that a coordinated expansion raises demand more than the sum of individual measures. The coordination is difficult to achieve, particularly in times of stress, and it requires trust and mutual understanding of the benefits. The international dimension of demand management is a central theme of the analysis of stabilisation policy in an open world economy.