Equilibrium GDP and Prices - Recessionary Gap

A recessionary gap occurs when the AD curve intersects the short-run AS curve at a short-run equilibrium level of GDP below potential GDP. Equilibrium GDP is below potential GDP.

Possible causes of a recession:

Tightening of monetary policy

higher taxes

more pessimistic consumers and businesses

lower equity and housing prices

How does the economy return to full employment?

automatic, self-correcting mechanism

government action: fiscal policy(reduce taxes or increase government spending), monetary policy (central bank to lower interest rates or increase the money supply).

If a recession is caused by a decline in AD, the following conditions are likely to occur:

Corporate profits will decline.

Commodity prices will decline.

Interest rates will decline.

Demandfor credit will decline.

This suggests the following investment strategy:

Reduce investments in cyclical companies.

Reduce investments in commodities and/or commodity-oriented companies.

Increase investments in defensive companies.

This suggests the following investment strategy:

Increase investments in investment-grade or government-issued fixed-income securities.

Increase investments in long-maturity fixed-income securities.

Reduce investments in speculative equity securities and in fixed-income securities with low credit quality ratings.