What is contraction in the economic cycle?

Business Cycle Indicators

Economists watch certain macroeconomic indicators to gauge the condition of the economy. In the U.S., the Conference Board issues an index of several key economic indicators. There are three main types of economic indicators, including: leading indicators, lagging indicators, and coincident indicators.
Leading indicators considered predictors of economic trends. Analysts use these data to try to forecast changes in the business cycle. Examples of leading indicators include stock prices, building permits, average weekly initial claims for unemployment insurance and an index of consumer expectations.
Coincident indicators fluctuate simultaneously with the business cycle and reflect the current condition of the economy. Examples of coincident indicators include industrial production data, nonagricultural payroll data, and manufacturing and trade sales data.
Lagging indicators appear after the completion of economic trends and changes in the business cycle. Furthermore, they can be used to analyze the economy in retrospect or to confirm other economic data. Examples of lagging indicators include the following: average duration of unemployment, average prime rate charged by banks, and change in labor cost per unit of output.

Historic Data

To see historic business cycle data for the U.S., go to: nber.org/cycles

Conference Board Index

To see economic indicators issued by the Conference Board, go to: conference-board.org
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Small-business owners need to realize that business operates in cycles. During the growth or maturation phase, businesses purchase equipment and hire employees. Eventually, they grow so large they can't afford their growth anymore and enter a contraction stage where everything slows down. The contraction stage passes eventually, so a slowing of income doesn't necessarily mean a business will fail.

Balances Inflation

1. The contraction stage of the business cycle follows periods of great growth. As a small business grows, it may not be able to sustain its growth because its expenses begin outgrowing the profit it takes in. When this happens, the business has to slow down and may have to close offices or lay off employees to get its expenses and income back into balance. This also is known as the recession stage.

Effect on Economy

1. When a lot of small businesses experience the contraction stage at once, it causes an effect on the overall economy. Businesses lay off workers, which causes employees to worry about their jobs and people in general spend less money. This can lead to financial stress and more difficulty staying in business. Sometimes, the Federal Reserve Board will lower interest rates in an attempt to stimulate the economy.

Part of Cycle

1. Business owners who are currently experiencing the contraction phase need to remember that this is only one stage of a cycle and that business will pick up again. While many small businesses close their doors during a recession, if a business owner can afford to stay in business, he will eventually succeed again. Thus, business owners must make rational decisions about how to react during the contraction stage rather than panicking about the future of their businesses.

Length of Stage

1. The length of the contraction stage varies, based on several factors. If a business has had a long expansion period, it will have a longer contraction period to get back in balance. In addition, federal and state regulations can have an effect on how long the contraction phase of the entire economy lasts. For example, if the government raises the minimum wage or lowers interest rates, it will have an effect on the contraction stage.

Many people love a roller coaster’s thrilling ups and downs. When it comes to the economy, however, most people would prefer to avoid a wild ride. In fact, most like a smooth ride with very few dips. This episode of The Economic Lowdown podcast series describes how the economy moves through phases of the business cycle, and the role the Federal Reserve System plays in smoothing some of the ride's bumps.

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Transcript:

Do you enjoy roller coasters? Some coasters are mild, kiddy rides that never really go that high. After a peak, they gently slope back down and then head back up. Other coasters are wild rides with long steep slopes. It’s a thrilling ride—well, for most of the riders, anyway.

However, when it comes to the economy, most people prefer that it not be a wild ride. In fact, most prefer a smooth ride with very few dips in the track.

Economists use the term business cycle to describe the ups and downs, or fluctuations, in an economy. More specifically, the term refers to the fluctuating levels of economic activity over a period of time measured from the beginning of one recession to the beginning of the next. The upward and downward movements indicate specific phases of the business cycle.

The upward slope of the business cycle is called economic expansion. An expansion is a period when economic output increases. That is, more goods and services are being produced in the economy.

As the economy expands, businesses, or “firms,” tend to use more resources—including labor. In other words, as firms increase output, they usually hire more workers. As a result, when output rises, employment tends to rise as well.

So, economic expansion usually means that two key economic indicators are increasing—economic output and employment. In practical terms, this means that the economy is producing more of the goods and services that we want and more people have jobs. More jobs mean more people with incomes to purchase goods and services. These are favorable outcomes. And you can likely see how more employment and income can help push the economy to even higher levels of output.

It would sure be nice if the economy would expand continuously, but all expansions come to an end. In economic terms, they reach a peak, which, like on a roller coaster ride, is the point just before the downward movement begins.

The downward slope of the business cycle is called economic contraction. A contraction is a period when economic output declines. During this phase, the economy is producing fewer goods and services than it did before. When fewer goods and services are produced, fewer resources are used by firms—including labor. As firms decrease their output, they will hire few or even no new workers and often lay off some existing workers. As a result, when output falls, employment tends to fall as well.

Economic contractions often become recessions. A recession is a significant decline in general economic activity extending over a period of time. A general rule of thumb is that two consecutive quarters of economic contraction constitute a recession.

Recessions result in economic hardship for many people and can have long-lasting effects. For example, losing a job due to recession can lead to high levels of debt or the loss of key assets such as a house or a car. In addition, if people are unemployed for long periods of time, they might find it difficult to keep their work skills sharp, and they might find it difficult to find another job.

Recessions are unpleasant, but fortunately they don’t last forever. In economic terms, they reach a trough, which is the point just before the upward movement begins.

The initial increase in output contributes to economic recovery, which is movement back to the level of output that existed before the recession began. If output continues to increase beyond this previous high mark, then the next expansion begins.

So, who decides when the economy has moved to a new phase of the business cycle?

The National Bureau of Economic Research—the NBER—is a group of economists who, in addition to doing economic research, examine data and identify the specific starting dates for the phases of the business cycle. To make their decision, they examine a variety of economic data. Of course, time is needed to collect and analyze data, so there is a time lag between when a business cycle phase begins and when the NBER announces that it has begun. In the past, the time between an actual change and the NBER announcement has been anywhere from 6 months to 21 months. The NBER Business Cycle Dating Committee prefers to wait long enough and see enough data to minimize any doubts about the turning point.

The term “cycle” in business cycle can be misleading because it implies regularity. For example, the rinse cycle on my dishwasher is predictable: It always begins 45 minutes after the wash cycle begins, and it always lasts 9 minutes.

There is nothing regular about the business cycle, though. Recessions and expansions are unpredictable and their lengths vary. For example, according to the NBER, the shortest U.S. expansion lasted only 10 months, from March 1919 to January 1920. The longest expansion lasted 120 months, or 10 years, from March 1991 to March 2001. The shortest recession on record lasted only 6 months, from January to July in 1980, while the longest recession was over 65 months, or 5 years. It lasted from October 1873 to March 1879 and is known as “The Long Depression.”

Do you ever wish for a world without recessions? Well, it isn’t likely. What is more realistic are economic expansions that last for long periods and recessions that are brief. And, according to data, the trend has actually moved in that direction: Over time recessions have become less frequent and lasted for shorter periods.

Helping to make those two things happen is part of the role of the Federal Reserve. The Federal Reserve has been mandated by Congress to promote maximum employment and price stability—it’s called the Fed’s dual mandate. During a recession, output is below capacity, and there are many unemployed workers. To help the economy grow, the Federal Reserve uses its monetary policy tools to decrease interest rates. Lower interest rates encourage consumers to borrow money—for example, to buy cars or homes, and businesses to invest and expand.  This borrowing and spending will cause firms to increase their output to meet the growing demand. As output increases, firms will likely use more resources and hire additional workers. Eventually, more resources, more workers, and more output will move the economy from recession to expansion again. In this way, the Federal Reserve uses its monetary policy tools to promote “maximum employment”—one component of the dual mandate—and smooth the business cycle.

To fulfill its “price stability” mandate—so, to keep prices low and stable—the Federal Reserve tries to keep inflation in check. The Fed wants to keep inflation around 2 percent. When inflation remains low and stable over time, businesses and individuals can plan their future investment and spending because prices remain fairly predictable. Such price stability promotes economic expansion, which, as we’ve discussed, also promotes employment. In effect, as the Federal Reserve pursues its dual mandate of maximum employment and price stability, it helps smooth some of the rough spots in the business cycle.

By design, a roller coaster has many ups and downs. However, when it comes to the economy, most people prefer a smooth ride with very few dips. It would be much easier to plan for the future if recessions were easy to predict, but they are not. Rather they are unpredictable and irregular. The Federal Reserve has a role to play in smoothing the rough spots out of the business cycle. The Fed uses its monetary policy tools to promote maximum employment and price stability in the economy. In other words, the Federal Reserve attempts to take some of the dips out of the economic ride to produce a smoother business cycle.

This podcast is brought to you by the Federal Reserve Bank of St. Louis. For more information, visit stlouisfed.org.

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