To illustrate an economy in a recessionary gap, we can use the standard Aggregate Demand and Aggregate Supply (AD-AS) model. In this diagram, the vertical axis represents the price level, while the horizontal axis indicates real GDP.
In a recessionary gap, the Aggregate Demand (AD) curve intersects the Short-Run Aggregate Supply (SRAS) curve to the left of the Long-Run Aggregate Supply (LRAS) curve. The LRAS represents the full employment level of output, indicating the maximum sustainable output level of the economy without causing inflation.
In this situation, the economy is producing below its potential output, and unemployment is higher than the natural rate. This gap reflects underutilization of resources, which can lead to a decrease in overall economic activity and consumer spending.
Now, when examining the economy in a recessionary gap in terms of the Production Possibility Frontier (PPF), there are two types to consider: the Institutional PPF and the Physical PPF.
The Physical PPF represents the maximum feasible output combinations of two goods produced by an economy, given its resources and technology at full employment. An economy stuck in a recessionary gap will operate inside this frontier, indicating that there are unutilized resources.
The Institutional PPF, meanwhile, considers factors like labor laws, regulations, and institutional frameworks that can affect production. When the economy is in a recession, it may also lie within this institutional boundary, represented by lower output due to various restrictions or inefficiencies in how resources are allocated and utilized.
In summary, a recessionary gap reflects an economy’s inability to reach its full potential, illustrated through the AD-AS model and seen in both the Physical and Institutional PPFs, indicating various levels of inefficiency and resource underutilization.