Contraction: Definition, How It Works, Examples, and Stages

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.

How Contraction Works

In general, a business cycle is composed of four phases through which an economy passes in the following order: expansion, peak, contraction, and 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. GDP and per capita income subsequently decline, unemployment ticks up, and stock market indexes trend downward.

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.

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.

Examples of Contractions in the US

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.

When the COVID-19 pandemic spread to the U.S. in March 2020, the economic impact of travel and work restrictions ended a peak in the U.S. economy and the longest economic expansion in its history—June 2009 to February 2020. Following the roll-out of vaccines in 2021, the U.S. economy experienced a strong recovery into 2022. By mid-2022, the Federal Reserve started to raise interest rates to curb inflation, increasing the risk of a recession. On August 16, 2022 President Biden signed into law the Inflation Reduction Act, the aim of which is to lower inflation, invest in energy production, and reduce healthcare costs.

The Bottom Line

A contraction is the third of four phases of the business cycle and refers to an economy in decline. The other three phases are expansion, peak, and trough. A key economic indicator to measure business cycles is real GDP. Contractions can last for months or years. The longest economic contraction in U.S. history occurred during the Great Depression.