Recessionary Gap

A recessionary gap occurs when AD and SRAS curve intersect at such a position that yields a GDP level which is less than the potential GDP. Such a situation is shown in where the equilibrium level of income is Y0 which is less than the potential GDP, Yf, and has thus, given rise to recessionary gap Y_f – Y₁. One way to restore equilibrium back at Yf is to wait for operation of the mechanism of wage and price reduction and downward (rightward) shift in the SRAS0 to SRAS1 and thus give the required full employment GDP, Y_f, which would be accompanied with a fall in price level from P₀ to P₁. But, as the experience of the various economies passing through recession shows that such adjustment is too slow and prolonged over a substantially long time period creating problems and tensions arising out of continued unemployment, falling price and loss of business incentives.

The fiscal policy prescription in this case is to reduce taxes (that raise disposable income and consumption level) and raise government spending, which together would increase aggregate demand. This would shift the AD curve upward (rightward) from AD₀ to AD₁ as shown in the new (AD₁) intersects the long-run supply curve LRAS at E₁ to give full employment equilibrium level of income Yf thus eliminating the recessionary gap. It may be noted that this process of removing the GDP gap is quicker and effective in substantially shortening the phase of recession that would have been otherwise a prolonged affair. It is, however, accompanied by a rise in price level from P₀ to P₂ as the equilibrium position moves from E₀ to E₁ on the SRAS curve.

Using this fiscal policy instrument of tax cuts and spending increase is that it may stimulate the economy and encourage private spending. This may add to the public spending and reinforce increase aggregate demand so that the process of recovery becomes still quicker. But if the stimulus to private spending continues even after the economy reaches full employment level, the AD may shift further upward to raise GDP level beyond its potential. This will give rise to inflationary gap. In such a case the fiscal policy that was intended to restore economic stability may actually introduce instability in the economy.