CONTRACTION: A phase of the business cycle characterized by a general period of declining economic activity. A contraction is one of two basic business cycle phases. The other is expansion. The transition from contraction to expansion is termed a trough and the transition from expansion to contraction is termed a peak. The popular term for contraction, one that frequently shows up in the media, is recession. A business-cycle contraction is a general downturn in economic activity, so named because the aggregate economy is "contracting" or growing smaller. A contraction is the seemingly inevitable phase of the business cycle that sets in after the economy has been expanding for several years. A primary goal of macroeconomics is to explain why contractions occur and then to recommend what policies can prevent them. Making if Official A contraction is officially designated, by the official designators at the National Bureau of Economic Research, as at least six months of declining economic activity. Six months is used because anything less is likely to be just a temporary, inconsequential blip in the data. And because many indicators are reported quarterly (that is, every three months), two straight quarters of declining activity is a good indication of an economic slowdown. Although six months is the minimum time needed for a contraction to be official, they typically last for about a year and often persist for up to eighteen months. The longest contraction on record continued for 43 months from August 1929 to march 1933 during the first few years of the Great Depression. In fact, in the minds of many, the contraction from 1929 to 1933 WAS the Great Depression. However, the Great Depression also contained a second, shorter contraction of 13 months from May 1937 to June 1938. While contractions are frequently indicated by a decline of real gross domestic product of about 10 percent, they also show up in many aggregate measures of economic activity. The unemployment rate rises above the full employment level of 5 percent, generally reaching at least 6 percent, but also going as high as 10 percent. The inflation rate tends to be lower during a contraction. Aggregate expenditures on gross domestic product, especially investment and to a lesser degree consumption, also decline. A Graphical Downturn A Shaded Contraction The diagram at the right presents a simple business cycle. The red line represents the value of real gross domestic product (real GDP) over a period of several months. The blue line is potential real GDP, the amount of real GDP that the economy can produce by fully employing all resources. Click the [Contraction] button to highlight the contraction phase of this business cycle. The shaded segment of the real GDP line between points A and B is the contraction. Clearly real GDP declines over this segment. A contraction generally takes the economy from at or above the long-run trend to below the long-run trend. Because the long-run trend represents full employment, unemployment results when real GDP is below the long-run trend, or when actual real GDP is less than potential real GDP. Moreover, the lower real GDP dips below the long-run trend, then the greater is unemployment. The Good with the Bad Contractions are generally considered obstacles along the path of rising prosperity and rising living standards. The perpetual problem of scarcity is better addressed when the economy expands. Contractions definitely have a number of "bads" that are best avoided. Here are a few worth noting: First, real GDP declines. During a contraction the economy has less production available to satisfy wants and needs, or to use for capital investment, or to provide government services. The overall size of the economic pie grows smaller. This is not good. Second, unemployment increases. Labor and other resources are unemployed because the economy produces less and thus their services are not needed. A small fraction of labor resources tends to be particularly hard hit. They get less income, possibly none at all. In a typical downturn about 2 to 5 percent of the labor force, which is several million workers who would be working otherwise, find themselves unemployed. Third, employed workers suffer. Many of the millions of workers who remain employed are likely to encounter their own problems. They might miss out on pay raises or their incomes fall because they work less. They too are likely to suffer, even though they officially remain employed Fourth, profits fall and bankruptcies rise. When the economy goes down, business profits also decline. In some cases, this might be a minor inconvenience to the corporate bottom line. In other cases, a business might even be forced into bankruptcy. Fifth, social problems rise. As economic times worsen so too do assorted social problems. Poverty goes up. Crime rises. Alcoholism worsens. Marital disputes are greater. However, as any optimist knows, there is a little good in all things, including contractions. One, inflation is low. Inflation tends to stay low or even decline during a contraction. For those prone to suffer from inflation, this is especially good. Two, efficiency improves. Another good is that resources are given the opportunity and incentive to be more efficient as they move from one production activity to another. This is also good for the economy. Expansionary Policies Expansionary policies are designed to counter business-cycle contractions. The two most common are expansionary fiscal policy and expansionary monetary policy. Expansionary fiscal policy is increasing government purchases or reducing taxes. Greater spending by government can induce the business sector to produce more output and hire more employees. These workers then have more income to spend on other goods, which induces more production, employment and income, and which can then stimulate the economy out of a contraction. Government can also decrease taxes, which leaves more spendable income in the hands of the consumption-spending household sector. When consumers buy more output, business hire more employees. Once again, this can stimulate the economy out of a contraction. Expansionary monetary policy is an increase in the amount of money in circulation and a corresponding reduction in interest rates. With more money, households and business are able to spend more, buy more production, and counter the contraction. Along with the increase in the money supply, interest rates generally decline, which encourages expenditures made by borrowing. In both case, the economy can be stimulated out of a contraction. Check Out These Related Terms...      | business cycles | business cycle phases | expansion | peak | trough | recovery | recession | potential real gross domestic product | long-run trend | Or For A Little Background...      | full employment | macroeconomics | macroeconomic goals | mixed economy | economic analysis | production possibilities | unemployment rate | inflation rate | real gross domestic product | full employment | investment | And For Further Study...      | business cycle indicators | investment business cycles | political business cycles | demand-driven business cycles | supply-driven business cycles | stabilization policies | National Bureau of Economic Research | multiplier principle | aggregate market | aggregate demand decrease, short-run aggregate market | Keynesian economics | fiscal policy | monetary economics | monetary policy | Recommended Citation:      CONTRACTION, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2025. [Accessed: December 16, 2025].

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