What happens to prices in a recessionary gap?

In a recessionary gap, the economy is operating below its potential output, characterized by high unemployment and underutilized resources. In this scenario, overall demand in the economy is weak, leading to lower spending by consumers and businesses. As a result, the downward pressure on prices intensifies because excess supply exists; businesses may lower prices in an attempt to increase sales and attract customers.

When demand falls short of supply, it generates a deflationary effect or a reduction in the general price level, which is why prices tend to decline in a recessionary gap. This drop in prices can serve as a mechanism to restore equilibrium in the market, although it can also lead to challenges such as decreased revenues for businesses and further cuts in production or employment.

In contrast, the other options do not accurately depict the behavior of prices in this economic context. Rising prices are typically associated with inflationary pressures, which is not the case during a recession. Stability in prices is unlikely when the economy is facing significant demand shortfalls, and wild fluctuations would more typically occur in a volatile economic environment rather than in a sustained recessionary gap. Overall, prices falling in a recessionary gap reflects the substantial imbalance between supply and demand that characterizes this period.