by Hanna Edwards

Created on: September 06, 2008   Last Updated: September 23, 2008

Depression is an economic term used to describe a prolonged or severe downturn in economic activity. Depressions have a more moderate counterpart recession that is a normal part of the business cycle of a free market economy. Recessions that linger or are exacerbated by extreme circumstances become characterized as depressions, though the reclassification is subjective and by consensus of economic analysts.

Free market economies are characterized by a business cycle that is like the ebb and flow of the ocean. The expansion phase is characterized by an increase in business activity, low unemployment, and upward pressure on wages, raw materials, and rents (inflation). Eventually, the price of doing business becomes so high that profitability suffers, and businesses will retrench by discontinuing marginal product lines and cutting jobs. Long term investment purchases (capital expenditures such as new machinery or airplanes) or new business commitments are put on hold. Employees - affected by the higher cost of living and uncertain job market cut their spending. The widespread occurrence of this retrenchment can spur the contraction phase of the business cycle, which can be considered a recession.

Recessions are often defined as a period of two or more consecutive quarters with negative growth in an economy's Gross Domestic Product. The Gross Domestic Product (GDP) is defined as the monetary value of an entire country's production (including goods consumed by its citizens, business capital investments, government spending, and goods produced for export) with the value of imported goods subtracted from that total. In macroeconomic theory, the reduction of GDP reflects lowered consumption and business investing. Other data taken into account include employment figures, industrial production, wholesale inventories, and real income, which is a calculation of the purchasing power of a household's wages. Note that decline of the stock market indexes is not considered to be an indicator of a recession.

Recessions are painful, but overall the contraction of the business cycle is healthy. Demand for raw materials and office space dips, and prices and rents become more negotiable. The business cycle contraction will wring some weak or ill-prepared competitors out of the market place, but it also allows new businesses to start out in a lower-expense environment. A new cycle of spending by new and surviving companies usually is enough to start the business cycle with a new expansion

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