CONTRACTION

 Contraction:

•  The economy cannot continue to grow endlessly. As mentioned above, once peak is reached, increase in demand is halted and starts decreasing in certain sectors. During contraction, there is fall in the levels of investment and employment.
•  Producers do not instantaneously recognise the pulse of the economy and continue anticipating higher levels of demand, and therefore, maintain their existing levels of investment and production.
•  The consequence is a discrepancy or mismatch between demand and supply. Supply far exceeds demand. Initially, this happens only in few sectors and at a slow pace, but rapidly spreads to all sectors.
•  Producers being aware of the fact that they have indulged in excessive investment and over production, respond by holding back future investment plans, cancellation and stoppage of orders for equipments and all types of inputs including labour.
•  This in turn generates a chain of reactions in the input markets and producers of capital goods and raw materials in turn respond by cancelling and curtailing their orders. 
• This is the turning point and the beginning of recession. 
• Decrease in input demand pulls input prices down; incomes of wage and interest earners gradually decline resulting in decreased demand for goods and services.
•  Producers lower their prices in order to dispose ou their inventories and for meeting their financial obligations. Consumers, in their turn, expect further decreases in prices and postpone their purchases.
•  With reduced consumer spending, aggregate demand falls, generally causing fall in prices. The discrepancy between demand and supply gets widened further. 
• This process gathers speed and recession becomes severe. Investments start declining; production and employment decline resulting in further decline in incomes, demand and consumption of both capital goods and consumer goods.
•  Business firms become pessimistic about the future state of the economy and there is a fall in profit expectations which induces them to reduce investments. 
• Bank credit shrinks as borrowings for investment declines, investor confidence is at its lowest, stock prices fall and unemployment increases despite fall in wage rates.
•  The process of recession is complete and the severe contraction in the economic activities pushes the economy into the phase of depression.