What happens to the price level and output during a recessionary gap? What type of fiscal policy is used to return the economy to equilibrium during a recessionary gap?
When there is a recessionary gap in an economy, that economy’s price level and its overall production both go down. When an economy is in a recession, its real GDP is declining. This clearly means that its production is declining. When production declines, price levels decline as well because the aggregate demand curve is moving to the left along a given aggregate supply curve. (Follow the link below for an interactive graph showing this and a more in-depth discussion of recessionary gaps.)
Typically, when there is a recessionary gap governments try to lower taxes and/or increase government spending. These are the classic Keynesian recommendations for fiscal policy in times of recession. If the government takes either or both of these actions, there will be more money in the hands of consumers. They will give less of their paychecks to the government and/or more people will get paychecks from the government through new government spending. Either way, people have more money. When people get more money, they typically spend it. When this happens, aggregate demand increases. When aggregate demand increases, the economy can return to equilibrium.