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.
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.
