What Is a Contracting Economy

In general, a government receives credit or debt for the state of the economy during its time. [65] This led to disagreements about how it actually began. [66] In an economic cycle, a slowdown can be seen as the result of an expansion that reaches an unsustainable state and is corrected by a brief decline. Therefore, it is not easy to isolate the causes of certain phases of the cycle. The Federal Reserve designs its monetary policy to guide the business cycle. The period following a low point is the expansionary phase that the Fed initiates through interest rate cuts and injections of money into the financial system. To add money, the Fed buys government bonds on the open market. This replaces bonds held in portfolios with cash that investors invest in banks. Banks, in turn, are eager to lend that extra money. Businesses are taking advantage of the availability of credit and low interest rates to buy factories and equipment and hire employees so they can manufacture more products and services to meet growing consumer demand as the economy improves. While GDP is the most important measure for assessing the health of the economy and defining the phase of a business cycle, the side effects of contraction are what the public feels most.

Reduced productivity almost always leads to higher unemployment and lower wages, as less labor is available with lower output. If more people are unemployed or their incomes are reduced, less money is spent in the economy, which can further exacerbate the contraction. From November 1973, the economy contracted until March 1975, but it was relatively moderate. The economy contracted by 0.5% in 1974 and by 0.2% in 1975. It started in January 1980. It seemed like it would be over in six months. President Ronald Reagan took office in 1981. The Fed started cutting interest rates because inflation was at a normal level. But the contraction returned in July 1981 and lasted until November 1982. The economy contracted in six of the 12 quarters.

As a result, GDP fell by 0.3% in 1980 and by 1.8% in 1982. In 2008, the Great Recession was the worst contraction in the United States since the Great Depression. The economy contracted by 0.1% in 2008 and by 2.5% in 2009. After the end of the Great Recession, an expansion began that lasted 128 months, the longest in the history of U.S. business cycles, dating back to 1854 and ending with the COVID-19 crisis in the spring of 2020. Markets then recovered from the initial COVID crash and reached new highs in the summer of 2021. In April 2009, Federal Reserve Vice Chair Janet Yellen discussed these paradoxes: “When this massive credit crunch hit, it didn`t take long for us to be in recession. The recession, in turn, exacerbated the credit crunch as demand and employment declined and credit losses by financial institutions increased. In fact, we have been in the grip of this negative feedback loop for over a year.

A process of deleveraging the balance sheet has spread to almost every corner of the economy. Consumers are retreating to their purchases, especially durable goods, to build up their savings. Companies are cancelling planned investments and laying off workers to save money. And financial institutions are reducing their assets to strengthen their capital and improve their chances of weathering the current storm. Once again, Minsky understood this dynamic. He spoke of the deleveraging paradox, where precautions that can be wise for individuals and businesses – and which are indeed essential to bring the economy back to a normal state – nevertheless add to the distress of the economy as a whole. [26] Due to a credit crunch, the economy had fallen into a brief recession in 1961. Australia faced a rise in inflation in 1973, in part because of the oil crisis of the same year, which increased inflation by 13%. The economic recession was reached in mid-1974 without changing the policy adopted by the government as a measure to combat the country`s economic situation. As a result, unemployment and the trade deficit have increased significantly. [80] The economic contraction ends when the Fed lowers interest rates and raises the money supply, as it becomes profitable for companies to finance their growth through bank loans. When companies enter the expansion phase of the business cycle, they also hire employees and raise wages.

This gives consumers more money to spend, and their purchases of low-interest homes and cars fuel the expansion of the economy. High debt or the bursting of a housing bubble or financial asset prices can lead to a so-called “balance sheet recession.” This is when a large number of consumers or businesses pay off (i.e., save) their debts instead of spending or investing, slowing down the economy. The term balance sheet is derived from an accounting identity, which states that assets must always be equal to the sum of liabilities plus equity. If asset prices fall below the value of the debt contracted for the purchase, equity must be negative, which means that the consumer or business is insolvent. Economist Paul Krugman wrote in 2014 that “the best working hypothesis seems to be that the financial crisis was just a manifestation of a broader problem of excessive debt – that it was a so-called `balance sheet recession`. According to Krugman, such crises require debt reduction strategies combined with higher public spending to offset declines in the private sector as it repays its debt. [17] In July 1953, the economy contracted by 10 months due to the end of the Korean War.