Contraction Definition
Reviewed by
ROBERT C. KELLY Updated Dec 30, 2020
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 activity—has declined for two or more consecutive quarters, then a recession 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, from 1929 to 1933. 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.
Related Terms
Trough Definition
A trough, in economic terms, can refer to a stage in the business cycle where activity is bottoming, or where prices are bottoming, before a rise. more
Economic Cycle Definition
The economic cycle is the ebb and flow of the economy between times of expansion and contraction. more
Expansion Definition
Expansion is the phase of the business cycle where real GDP grows for two or more consecutive quarters, moving from a trough to a peak. more
A peak refers to the pinnacle point of economic growth in a business cycle before the market enters into a period of contraction. more
Business Cycle
The business cycle depicts the increase and decrease in production output of goods and services in an economy. more
Depression Definition
An economic depression is a steep and sustained drop in economic activity featuring high unemployment and negative GDP growth. more
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