What is a 'Contraction'?

A contraction is a phase of the business cycle in which the economy as a whole is in decline. Contraction occurs after the business cycle peaks but before it becomes a trough. According to most economists, a contraction is said to occur when a country's real GDP has declined for two or more consecutive quarters.

BREAKING DOWN 'Contraction'

For most people, a contraction in the economy is a precursor to economic hardship. As the economy plunges into a contraction, unemployment increases. While no economic contraction lasts forever, it is difficult to assess just how long a downtrend will continue before it reverses. History has shown that a contraction can last for many years, such as during the Great Depression.

The Business Cycle

The business cycle is composed of four discrete phases, and the economy moves through them in a specific order: expansion, peak, contraction and trough. During economic expansion, gross domestic product (GDP) rises, per capita income grows, unemployment declines and equity markets tend to perform well. The peak phase represents the end of an expansionary period after which contraction takes hold. GDP and per capita income decline, unemployment ticks up and stock market indices trend downward.

The most-watched indicator of economic contraction is GDP. A recession is officially signaled when GDP contracts for two consecutive quarters in the United States, The end of a contractionary phase is marked by a trough. This is the nadir of a recession or downturn, what many refer to as "rock bottom." A new period of expansion begins after a trough.

Effects of Contraction

While GDP is the primary measure used to assess the health of the economy and the phase of the business cycle, the ancillary effects of contraction are what the public feels the most. Decreased productivity almost always precipitates higher unemployment and lower wages because less work is available when production is low. When more people are unemployed or have their incomes cut, less money is spent and active in the economy, which can further exacerbate contraction.

Famous Periods of Contraction

The longest and most painful period of contraction in modern American history was the Great Depression, which lasted for a full decade, from 1929 to 1939. More recently, deep contraction occurred during the early 1980s when the Federal Reserve sent interest rates soaring to squelch inflation. This contractionary period, however, was short-lived and was followed by a robust and sustained period of expansion. The Great Recession of 2007 to 2009 was a period of substantial contraction spurred by an unsustainable asset bubble in the real estate and financial markets.

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