Contraction Phase

Updated on February 22, 2024
Article byAswathi Jayachandran
Edited byAswathi Jayachandran
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Contraction Phase?

The Contraction Phase is the period of change or downswing in a business cycle when moving towards a trough. It is described as the decline of output from peak to trough. This part of the business cycle is often associated with a decrease in output or production.

Contraction Phase

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A pattern of rising and declining real gross domestic product (GDP) is called a business cycle, sometimes referred to as a trade cycle. Four phases usually make up the cycle: peak stage, contraction stage, trough stage, and expansion stage. The length of business cycles and the rate of change in real GDP vary and are not consistent.

Key Takeaways

  • The contraction phase is a part of the business cycle. The phase represents the decline in economic activity, a rise in unemployment levels, and low wages.
  • A business cycle is characterized by swings in the real GDP or output level relative to the economy’s long-term trend growth rate over a given period.
  • During economic contractions, economic activity reduces. The Central Bank of countries typically reduces cash rates and interest rates, reducing borrowing costs and causing individuals to borrow more and save less.

Contraction Phase Of Business Cycle Explained

The contraction phase is the time frame in which there is a fall in aggregate demand coupled with a decrease in economic activity and an increase in unemployment. It is a part of the business cycle. Variations in the degree of economic activity are reflected in business cycles. During this phase, businesses see fewer sales due to less demand. A decreased production of goods and services responds to a decrease in sales. It is reflected in the level of people employed. Businesses may even reduce their workforce by letting off employees. It is because they already have enough labor available, and there is little demand to increase the workforce.

Contraction Phase Of Business Cycle

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Additionally, when economic contraction happens, there is competition for existing jobs due to high unemployment; labor will be available even at low wages. Since people earn less, they also tend to spend less. They mostly spend on necessities and spend even lesser amounts on other goods and services. They might be more inclined to save since they might be more worried about losing their jobs instead of spending their cash.

Speaking on a broader range, during the economic contraction, the central bank or Federal Reserve in the U.S. mostly cuts the cash rate if economic growth is too sluggish. Similarly, interest rates get lowered by commercial banks, resulting in decreased borrowing costs. Individuals may typically borrow/spend more and save less.

Examples

Let us look into a few examples to understand the concept better.

Example #1

Suppose ABC Clothing, a renowned clothing firm, has gone through a contraction phase, which is a time of decreased demand and an economic slowdown. The business has seen a fall in foot traffic, a reduction in customer orders, and a significant drop in overall sales, all of which point to a declining market for its goods. Customer feedback, sales data analysis, and market research have all pointed to a decline in the demand for their products.

ABC Clothing has undertaken layoffs in order to preserve financial stability and match worker size with decreased production requirements. Controlling costs, allocating resources as efficiently as possible, and preserving profitability during the contraction period were goals of such a move.

Example #2

Japan‘s economic recovery from the epidemic lost its momentum during the summer of 2023. With the most significant decline since March 2020, Japan’s GDP shrank by an annualized 2.9% in the three months ending in September (2023). The outlook is also bleak, with domestic demand being burdened by sticky inflation and slowing foreign economies. The report also indicates symptoms of weakening for consumption. This indicates the contraction phase that the country passed through.

Graph

Let us understand the contraction phase with the help of a graph. Through the following graph, one can get a comprehensive overview of critical economic indications during a business cycle.

Contraction Phase Graph

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Contraction Phase vs Expansion Phase 

The contraction and expansion phases are two critical stages in the business cycle, each characterized by distinct economic indicators and impacts on the market. Let’s understand their differences from the table below:

BasisContraction phaseExpansion phase   
ConceptThe contraction phase refers to the downward movement of the business cycle toward a trough.  Economic expansion refers to the upward movement of the business cycle towards a peak.  
production or outputIn an economic contraction, When companies see a decline in sales or customer demand for their items, the output of goods and services also declines.  When the economy grows, businesses usually see an increase in sales or demand for their goods, which prompt an increase in the production of goods and services.    
unemploymentIn a contraction, businesses may reduce their workforce size as a result of reduced production to meet demand, leading to an increase in unemployment.  Businesses need to increase production and hire more workers to meet demand, which will decrease unemployment levels.  
WagesReduced company performance is causing businesses to contract, which enables them to recruit people at lower wages.   Businesses must pay more to attract and retain employees because the economic activity is high.  
Consumer spendingLower wages lead to reduced spending on goods and services, as individuals may be more concerned about job loss, resulting in a preference for saving over spending.  Higher wages lead to increased economic spending, thereby increasing demand.

Frequently Asked Questions (FAQs)

1. Is contraction phase of the business cycle longer than the expansion phase?

The length of the contraction phase in the business cycle can vary and is not necessarily more extended than the expansion phase. Several factors, including the severity of economic downturns and the effectiveness of government policies, influence the duration of each phase.

2. What are the causes of contraction phase of a business cycle?

The contraction phase of a business cycle arises from various causes, such as decreased consumer spending, reduced business investments, declining demand for goods and services, changes in government policies, financial crises, and external shocks such as global economic recessions or natural disasters.

3. Is the contraction phase also called recession? 

The contraction phase is a stage in the business cycle where economic activity declines, but it is not synonymous with a recession. A recession refers explicitly to a more pronounced and prolonged period of economic downturn, typically defined as two consecutive quarters of negative GDP growth. While a contraction phase can lead to a recession if it is severe and extended, not all contraction phases result in a recession.

This article has been a guide to what is Contraction Phase. Here, we explain the concept along with its examples, graph, and comparison with expansion phase. You may also find some useful articles here –

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