Economic Contraction: Meaning, Causes and Impacts

Economic contraction occurs when aggregate economic activity decreases. Aggregate output measures, such as real GDP and industrial production, show a decline compared to the previous period. If real GDP falls in two consecutive quarters, economists call it a sign of recession. A severe recession is called depression. Hence, both recession and depression are a worse condition of contraction.

Let’s discuss the business cycle briefly

The contraction phase occurs after the peak phase (peak phase). Meanwhile, if the contraction reaches its lowest point, this is called the trough phase (trough phase). After going through a trough, the economy recovers and expands.

Aggregate economic activity usually experiences an up and down phase, which is often called the business cycle or economic cycle. The cycle consists of four stages, namely expansion, peak, contraction, and trough.

Expansion. Rising inflationary pressures usually follow aggregate output increases. And then, we call the last part of the expansion as an economic boom.
Peak. Aggregate output is at the highest level. In general, real GDP is above its potential. As the economy reaches its peak, high inflationary pressure occurs, causing the economy to overheat.
Contraction. Aggregate output falls, inflationary pressure eases, and deflationary pressures begin to emerge.
Trough. It is the lowest level of the business cycle. If, for example, economic policies effectively stimulate economic activity, real GDP will begin to recover before going into an expansion phase.

What causes economic contraction?

Several factors cause an economic contraction, including:

Tighter monetary policy
Contractionary fiscal policy
Increased real wages and production costs
Global economic downturn
A decline in asset prices

Tighter monetary policy

As the economic boom occurs, the central bank will tighten monetary policy. During this period, inflation rises at accelerating rates. A boom can explode and if it is not prevented, causing the economy to collapse. Hence, to reduce inflation and prevent the economy from overheating, central banks take a contractionary monetary policy.

In that case, central banks reduce the money supply in the economy. To do, they have several tools, including policy rate, open market operation, and reserves requirement.

Let’s assumes central banks choose to raise the policy rate. The higher interest rate makes loans more expensive. It will reduce lending growth and aggregate demand in the economy.

A moderate increase might only slow down economic growth. But if interest rates rise too high, this can cause economic growth to fall.

How higher policy rates reduce aggregate demand

When the policy rate increases, the lending rate would also adjust up. Borrowing costs are more costly. As a result, consumers and businesses reduce the demand for loans from commercial banks. They then cut spending on goods and services, especially durable goods for consumers and capital goods for business.

Lower spending of consumers and business causes aggregate demand to fall. It then pushes real GDP down. If the short-run equilibrium is below the potential output, this causes deflationary pressures, meaning that inflation to be moderate.

Contractionary fiscal policy

If the central bank uses monetary instruments to moderate inflation, governments intervene in the economy through budgetary instruments. There are two tools for fiscal policy, namely government spending and taxes.

When the goals are to moderate inflation and economic growth, we call the government’s policy as contractionary fiscal policy. This term is synonymous with tighter fiscal policy or loose fiscal policy.

During the economic boom, the government would reduce spending or raise taxes to conducts tighter fiscal policy. Cutting spending reduces aggregate demand in the economy.

Likewise, higher taxes reduce the household’s disposable income. With less money in hand, consumers spending less on goods and services. As a result, aggregate demand also decreases.

Increase real wages and production costs

Wages usually account for a large portion of production costs. Thus, any increase in wages will reduce profit margins. Similarly, an increase in the price of raw materials or energy raises production costs, squeezing profit margin.

Oil prices are one factor that has a significant impact on the economy. It is because oil uses are in almost all industries, including raw material, energy, and fuel. Oil price shocks could cause a sharp decline in economic growth, and can even cause stagflation.

How wages affect economic growth

When inflation is high, it erodes the purchasing power of money wages (nominal wages). During an economic boom, real wages typically fall because money wages rise lower than the inflation rate.

That situation forces workers to renegotiate nominal wages to keep up with inflation. If nominal wages increase higher than the inflation rate (real wages are higher), the producer’s marginal profit decreases, meaning that they face higher production costs than revenue when producing one more output. Thus, they see no benefit in increasing production.

A decline in the global economy

The global recession can affect the domestic economy through trade in goods and services, as well as through financial transaction channels. Global recession lowers the demand for domestic products. Exports fell and reduce aggregate demand and economic growths.

Such impacts have become increasingly significant recently in line with globalization and trade connectivity among countries.

A decline in asset prices

The economic boom, if not anticipated, causes a sharp decline in asset prices. Such decline dramatically reduces household wealth, driving them to spend less on goods and services.

The subprime mortgage crisis in the United States during 2008-2009 is an example. The crash in housing prices caused many large financial institutions to collapse and cause a disaster. It then spread throughout the economic sector and caused economic growth in the United States to fall from 1.9% in 2017 to -0.1% in 2008 and -2.5% in 2009.

Real GDP Growth in the United States 1964-2018

What happens during an economic contraction?

As economy contracts, real GDP declines, and its growth moves to negative territory. Other economic activity indicators, such as industrial production and retail sales, also grow negatively. Household demand for goods and services, especially durable goods, fell.

Businesses end up with excess inventory because of more products unsold. Often, they offer discounts or lower selling prices to avoid inventory buildup. If more companies choose to cut their sales, the price level (inflation) in the economy can decrease.

At the same time, businesses adjust production levels by employing physical capital less intensively. They spend less on maintenance or by delaying the replacement of equipment that is nearing the end of its useful life. They also began to rationalize operational costs by reducing overtime payments.

When weakening consumer demand remains, the company reduces production. They also cut investment spending and take the option to lay off workers. As a result, the unemployment rate began to rise.

Facing the weaker outlook of income and employment, consumers reduce their spending, so aggregate demand decreases. If there is no intervention by policymakers, a decrease in aggregate demand could bring the economy into a deep recession (deep recession).

How to solve the contraction

Usually, policymakers would intervene by adopting expansionary policies to recover the economy. Governments would increase their spending or reduce tax rates. Alternatively, central banks can take expansionary measures, for example, by cutting policy rates.

If effective, both policies can boost aggregate demand in the economy. Rising aggregate demand will stimulate the economy to recover.

Economic Contraction: Meaning, Causes and Impacts

Let’s discuss the business cycle briefly