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.

RELATED TERMS
  1. Trough

    A trough is the stage of the economy's business cycle that marks ...
  2. Expansion

    Expansion is the phase of the business cycle when the economy ...
  3. Peak

    Peak refers to the pinnacle point of economic growth in a business ...
  4. Economic Recovery

    An economic recovery is a period of increasing business activity ...
  5. Cyclical Industry

    A cyclical industry is sensitive to the business cycle, meaning ...
  6. Economic Cycle

    The economic cycle is the ebb and flow of the economy between ...
Related Articles
  1. Investing

    Business Cycle

    The business cycle refers to the fluctuations in economic activity that an economy experiences over a period of time. It consists of expansions, or periods of economic growth, and contractions, ...
  2. Trading

    The Difference Between Forwards and Futures

    Both forward and futures contracts allow investors to buy or sell an asset at a specific time and price.
  3. Trading

    Market Cycles: The Key to Maximum Returns

    You need to understand the various phases of the market cycle to avoid bubbles and make the best investments.
  4. Insights

    The GDP and its Importance

    GDP is an accurate indication of an economy's size. Few data points can match the GDP and its growth rate's conciseness.
  5. Insights

    Recessions and Depressions Aren't So Bad

    Downturns like depressions and recessions are a natural part of the economic cycle and can actually provide some benefits.
  6. Insights

    A Review Of Past Recessions

    Here we look at the biggest economic declines in the U.S. since the Great Depression.
RELATED FAQS
  1. Forward Contracts vs. Futures Contracts

    While both forward and futures contracts allow people to buy or sell a specific asset at a specific time at a given price, ... Read Answer >>
  2. How are futures used to hedge a position?

    Futures contracts are one of the most common derivatives used to hedge risk. Learn how futures contracts can be used to limit ... Read Answer >>
  3. What is a forward contract against an export?

    Understand forward exchange contracts in exporting, and learn the purpose of using a forward contract and its advantages ... Read Answer >>
Hot Definitions
  1. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  2. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  3. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  4. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  5. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  6. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
Trading Center