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What are Credit Contractions?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 09 September 2016
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Credit contractions are attempts to minimize or limit the amount of credit that is currently available to consumers. The use of a credit contraction is normally associated with the desire to slow the rate of inflation in the general economy. By creating a state of recession, credit contractions help to slow or even possibly stop any growth of inflation for a period of time.

The use of credit contractions makes it harder for consumers to obtain credit. At the same time, credit contractions may also help to encourage saving money in standard savings accounts and Certificates of Deposit. A result is that banks and other financial institutions improve their capital ratios and carry less debt in the form of mortgages and loans.

When credit contractions are implemented, the first consumers to feel the pinch are those who have borderline or bad credit ratings. Almost immediately, consumers in these categories find it impossible to obtain credit even with inflated rates of interest. This can mean that someone with a poor credit rating may have to forego purchasing a new vehicle or take out a second mortgage on property.

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However, credit contractions do not necessarily impact only people with bad credit. Depending on the severity of the strategies put in place, even consumers with excellent credit may no longer be eligible for obtaining credit increases or new loans. For example, a business that is stable and has an excellent credit rating may suddenly be unable to take out a loan to cover an upcoming project. Despite the excellent credit rating, banks may judge the project is risky in the current economic environment and not approve the loan.

Credit contractions are usually not long-term situations. Raising interest rates, a common type of credit contraction strategy, is usually in response to an economy that is undergoing a rapid rate of inflation. Once measures are taken to slow or possibly reverse the rate of inflation, interest rates may drop back to more acceptable levels. At that juncture, consumers who were unable to obtain credit or loans will suddenly be eligible again.

It is important to note that credit contractions do not always yield immediate results. The contractions may remain in place for anywhere from a couple of months to a year before the desired effect takes place. In the interim, consumers often will cut back on impulse spending and focus on purchasing necessities rather than luxury items.

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YogurtPark
Post 3

I think credit contractions are just a band-aid approach to solving an economic crisis. They do not heal the source of the wound, instead they just cover it up. We need to change the culture of American consumption, instead of just blocking access to lines of credit.

Too many Americans fall victim to credit card debt because they do not know how to properly save money. The concept of "buy now, pay later" has forced us into wanting things right away, instead of saving up and buying them when we could afford them. If the country wants to prevent recessions and inflation, then it needs to change the mindset of its citizens.

Also, banks and creditors support this

culture of mass consumption. They offer people with bad credit history, or little money down, loans with adjustable interest rates. When the rates go up, the people who got the loans cannot pay them back. This is not okay, and banks need to stop awarding loans to people who do not have the means to pay them back.

Credit contractions are not the answer to solving inflation problems. For a more permanent solution, we need to train the next generation on the importance of saving money and maintaining good credit. Good spending and saving habits are the only way to prevent inflation caused by consumers.

epiphany5
Post 2

@sehiggins - I agree with you one hundred percent. Credit contractions are sometimes necessary in times of economic crisis. They can encourage people to save money, instead of buying everything on credit or relying on a loan to make a big purchase. But, I do not think that honest, hardworking citizens or organizations who pay their bills on time should be hindered from making financial decisions. In fact, I think doing so can have negative effects on the economy.

For example, if a business wanted to take out a loan for a bank to purchase capital to manufacture a new product, and they could not get the loan because of credit contractions, then this stunts the business's growth. When businesses

can't grow, then they can't offer new jobs to the economy. In times of recession, job creation is one of the most important steps in recovery. Credit contractions could be counterproductive in the recovery process.

The same situation can be applied to an entrepreneur who wants to start his own business. If the bank denies his request for a small business loan because of credit contractions, then he can't open up shop. Small businesses are the backbone of the American economy. When you hurt them, you hurt everyone.

Credit contractions should therefore be used with great caution. If not, they can be more of a bad thing than a good thing.

sehiggins
Post 1

I can understand why governments decide to impose credit contractions. It can be a way to help the economy return to the way it was before inflation. However, I do not thing people with good credit should suffer because people with bad credit default on their loans.

The fact that credit contractions can possibly prevent people with good credit from getting a loan does not sit well with me. Why should they have to pay for the mistakes of others who caused the recession in the first place? It is not fair.

Instead, credit contractions should only be limited to people or institutions that have a tangible history of not paying back their loans on time. They are the reason that economies suffer, so they should be the ones that have to suffer the consequences.

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