What Is Contraction?
Contraction, in economics, refers to a phase of the business cycle in which the economy as a whole is in decline. A contraction generally occurs after the business cycle peaks, but before it becomes a trough. According to most economists, when a country's real gross domestic product (GDP)—the most-watched indicator of economic contraction—has declined for two or more consecutive quarters, then a contraction has occurred.
More About Contraction
For most people, a contraction in the economy is a precursor to economic hardship. As the economy plunges into a contraction, unemployment increases. Although 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.
A contraction generally occurs after the business cycle peaks, but before it becomes a trough.
The Business Cycle
A business cycle is composed of four discrete phases, through which the economy passes in this order: 1) expansion, 2) peak, 3) contraction, and 4) trough. During economic expansion, GDP rises, per capita income grows, unemployment declines, and equity markets generally perform well. The peak phase represents the end of an expansionary period after which contraction takes hold. Then GDP and per capita income decline, unemployment ticks up, and stock market indexes trend downward.
Effects of Contraction
Although GDP is the primary measure used to assess the health of the economy and define the phase of a business cycle, the ancillary effects of contraction are what the public feels 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, then less money is spent in the economy, which can further exacerbate contraction.
Real World Example—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 succeeded 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 bubble in real estate and the financial markets.