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Calculating the Size of a Contractionary Gap

Calculating the Size of a Contractionary Gap
Coming up next: What is an Expansionary Gap? - Identifying an Economy That is Above Potential

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  • 0:05 Contractionary Gaps
  • 1:37 Size of a Contractionary Gap
  • 4:32 Compare Actual Output…
  • 5:37 Subtract Potential Output
  • 7:10 Positive Side-Effect:…
  • 8:17 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

Sometimes the economy's actual production is below its potential, and in this lesson, you'll learn how to calculate the gap between the two, something economists call 'a contractionary gap.'

Contractionary Gaps

Like a long-distance runner who can only run so fast, our economy has a long-run potential, and throughout the business cycle, actual economic output is sometimes below that potential. That long-run potential is also referred to as potential output, and it's the real gross domestic product (or real GDP) that could have been produced by an economy if all the resources in the economy were fully employed - what economists call 'full employment.'

A simultaneous decrease in economic output and increase in unemployment creates a contractionary gap.
Economic Output and Unemployment Contractionary

When our economy sometimes falls below this potential output, you and I are probably more familiar with terms like 'recession' and 'economic slowdown,' but economists call this a contractionary gap, and it coincides with the down phase of the business cycle that tends to happen every five to seven years. Like the jogger who slows down for a little while, during these times, economic output is occasionally lower than normal and unemployment is higher than normal.

For the rest of this lesson, we're going to take a look at how economists calculate the size of a contractionary gap. Why is this important? It's important because it's the central bank's first step in the process of eliminating that gap. We'll also take a look at the silver lining, or positive benefit, of contractionary gaps.

The Size of a Contractionary Gap

So, let's get started. The size of a contractionary gap is the difference between actual and potential output measured in terms of real gross domestic product - or real GDP for short. Take a look at this example:

Below is a graph of economic output at a given point in time. As you can see, there are three lines on this graph. The vertical black line is the long-run aggregate supply, or LRAS for short; this line illustrates the economy's potential output. The red curve is the short-run aggregate supply, or SRAS curve, which is what producers are willing and able to sell. The blue curved line represents aggregate demand, or AD for short; this is what people are willing and able to buy. Just by looking at this graph, we can already tell that this economy has an actual output that's below its long-run potential simply because AD intersects the SRAS to the left side of the vertical LRAS. Here's another way to say it: what producers are willing to make and consumers are willing to buy falls to the left of the long-run potential.

Graph of economic output
Size of a Contractionary Gap

This is the exact opposite of an expansionary gap, so if this intersection took place on the right side of the LRAS, we'd be talking about an expansionary gap and how to measure that. If you want to picture an economy like the one I just described, just think about walking down the street of a popular urban area and seeing most of the retail stores empty of customers, signs in the windows saying, 'Major Sale - 50% off' and on some stores, signs that say, perhaps, 'For Lease' or 'For Sale.' At the same time, imagine that people are lined up for three blocks outside the unemployment office trying to apply for unemployment checks because they've been laid off.

Because we want the economy to rebound, let's calculate the size of this contractionary gap, which you can do for any example if you just understand the process. Begin by looking at point B, which represents the intersection of AD and SRAS, or what I said was called 'actual output.' Now move straight downward on the graph until you reach the scale at the bottom. As you can see below, it's $2 trillion on the scale of real GDP.

Using a graph, you can calculate contractionary gap.
calculating a contractionary gap

Compare Actual Output and Potential Output

Now, take a look at point A, which is on the vertical LRAS, then move straight downward until you once again reach the scale at the bottom of the graph. Notice that point A corresponds to a real GDP of $4 trillion. This is the economy's long-run potential that we talked about, and when you look at both of these things together, you realize there is a difference, or a 'gap,' between them.

Economists would say it this way: Actual output is $2 trillion while potential output is $4 trillion, and this creates a contractionary gap of $4 trillion minus $2 trillion, which is equal to $2 trillion. Before we move on, notice quickly that the price level on the left-hand side of the graph went down between these two points; we're going to refer back to this later.

Calculate the contractionary gap size by subtracting actual output from potential output.
Calculating Contractionary Gap Size 1

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