What is a Contractionary Gap? - Identifying an Economy That is Below Potential

What is a Contractionary Gap? - Identifying an Economy That is Below Potential
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Lesson Transcript
Instructor: Jon Nash

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

In this lesson, you'll discover what a contractionary gap is with a real world example. In addition, you'll learn how economists illustrate it, so you can easily recognize it.

Defining the Contractionary Gap

Throughout the business cycle, economic output is sometimes below its long-run potential. Like a long-distance runner who's running at her capacity but slows down temporarily to catch her breath, the economy sometimes slows down below its potential in the short-term.

Potential output is 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.'

Although you and I are probably more familiar with terms like 'recession' and 'economic slowdown,' economists call this scenario a contractionary gap, and it coincides with the down phase of the business cycle that tends to happen every 5-7 years.

When the actual output of the economy is less than its potential output, the gap between these two things is called a contractionary gap. During contractionary gaps, unemployment is much higher than usual.

At Margie's Bakery, Margie is busy baking world-class cakes. Times are good right now, and Margie is currently baking 1,200 cakes per week. And, she does this with five employees - employees that are working full-time, with regular hours. Now, imagine that the same situation holds true for businesses all across the economy - the unemployment rate is at its 'natural rate' (again, what the economists call 'full employment'). This is an example of an economy operating at its long-run potential.

Now, fast-forward with me two years. Let's say that, for some reason, consumers are more fearful about the future. Maybe the stock market declined and they don't feel as wealthy. Maybe they've borrowed too much and rising costs are squeezing their budgets. Whatever the cause may be, because they're less confident about the future, what happens is that they spend less money today.

In this kind of economic environment, sales for Margie's cakes fall from 1,200 cakes per week to 600 cakes per week - a dramatic decrease. As a result of watching her sales decline for many months in a row, she asks all her existing employees to sit down for a painful meeting in which she has to let go of three of her employees and keep only two of them in response to the lower demand.

Now, imagine this same event is happening in businesses all across the nation, and you'll have a great image of a contractionary gap. This is an example of an economy that's operating below its long-run potential. All across the economy, resources, including labor, are below the 'full employment' level and below the economy's potential.

Illustrating the Full Employment Level of Output

Let's first take a look at how economists illustrate potential output, or 'full employment,' using a graph of aggregate demand and aggregate supply. Then, we'll take a look at a second graph of a contractionary gap in order to compare the two graphs and learn how to easily recognize and identify a contractionary gap. As you look at these two graphs, I want you to focus on, and think about, where the blue and red lines intersect.

Graph illustrating the full employment level of output
Full Employment Level Graph

First, above is a graph showing you an economy that's operating at potential output, or 'full employment.' To keep things really simple, the blue line represents total demand, while the red line represents total supply, and the black vertical line represents the economy's potential long-run capacity. That black line is like a long-distance runner's pace, or when Margie's capacity is to produce 1,200 cakes per week. When the red and blue lines intersect at point b on this graph, you know that the economy is operating at its long-run potential. This is how economists illustrate 'potential output.'

To give you a little bit more insight into the graph, economists call the blue line 'aggregate demand' (or AD for short), and this represents the total demand for goods and services in the whole economy. The red line represents the short-run aggregate supply (or SRAS for short), and this is the total supply of goods and services in the whole economy. Finally, the black vertical line represents the long-run aggregate supply (or LRAS for short). So, what's happening here in this graph is that the supply and demand for the whole economy is taking place at its long-run potential.

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