Major military defeats, such as the Battle of Königgrätz in 1866, forced Emperor Joseph to accept internal reforms. To appease Hungarian separatists, the emperor made an equitable deal with Hungary, the Austro-Hungarian Compromise of 1867 negotiated by Ferenc Deák, by which the dual monarchy of Austria-Hungary came into existence. The two realms were governed separately by two parliaments from two capitals, with a common monarch and common foreign and military policies. Economically, the empire was a customs union. The first prime minister of Hungary after the compromise was Count Gyula Andrássy. The old Hungarian constitution was restored, and Franz Joseph was crowned king of Hungary. The nation of Austria-Hungary was geographically the second largest country in Europe after Russia. Its territories were appraised at 621,540 square kilometres (239,977 sq mi) in 1905.^[72] After Russia and the German Empire, it was the third most populous country in Europe.

The era witnessed significant economic development in the rural areas. The formerly backwards Hungarian economy became relatively modern and industrialized by the turn of the 20th century, although agriculture remained dominant in the GDP until 1880. In 1873, the old capital Buda and Óbuda (ancient Buda) were officially merged with the third city, Pest, thus creating the new metropolis of Budapest. Pest grew into the country's administrative, political, economic, trade and cultural hub.

Technological advancement accelerated industrialization and urbanization. The GDP per capita grew roughly 1.45% per year from 1870 to 1913, comparing very favorably to other European nations. The leading industries in this economic expansion were electricity and electro-technology, telecommunications, and transport (especially locomotive, tram and ship construction). The key symbols of industrial progress were the Ganz concern and Tungsram Works. Many of the state institutions and modern administrative systems of Hungary were established during this period.

The census of the Hungarian state in 1910 (excluding Croatia), recorded a population distribution of Hungarian 54.5%, Romanian 16.1%, Slovak 10.7%, and German 10.4%.^[73] The religious denomination with the greatest number of adherents was Roman Catholicism (49.3%), followed by Calvinism (14.3%), Greek Orthodoxy (12.8%), Greek Catholicism (11.0%), Lutheranism (7.1%), and Judaism (5.0%)