UPDATE 1-US Midwest business activity rises in July

NEW YORK,July 31 - Business activity in the U.S. Midwest improved in July, which was its strongest month since last September when Lehman Brothers' failure pushed the banking sector to the brink of collapse, a report showed on Friday.

The National Association of Purchasing Management-Chicago business barometer rose to 43.4 from 39.9 in June. Economists polled by Reuters had expected a reading of 43.0.

While that still marked a contraction of activity, the pace of contraction slowed. A reading above 50 indicates expansion.

"You are not above 50 yet but you are still well off the lows," said John Canally, an economist at LPL Financial in Boston, who said the data also shows a rebound in the sector following auto plant shutdowns in May and June.

The reading was the highest since the survey came in at 55.9 in September of 2008, the month when the financial crisis worsened following the collapse of Lehman Brothers.

Wall Street extended its gains after the data and the euro pushed higher against the dollar. U.S. government debt prices remained higher after the report.

A separate report Friday showed the U.S. economy contracted just 1 percent in the second quarter following a 6.4 percent contraction in the first three months of the year.

Canally said a reduction in business inventories in the second quarter also helped Midwest business activity improve.

"Now businesses everywhere are scrambling to meet demand," he said.

Within the survey, the index of new orders rose to 48.0 in July from 41.6 the prior month while employment rose to 35.3 in July from 28.9 in June.

The prices paid component slipped to 35.0 from 36.3.