5.1. Expansionary and Contractionary Fiscal Policy

Expansionary fiscal policy is defined as an increase in government expenditures and/or a decrease in taxes that causes the government's budget deficit to increase or its budget surplus to decrease. Contractionary fiscal policy is defined as a decrease in government expenditures and/or an increase in taxes that causes the government's budget deficit to decrease or its budget surplus to increase.

In case of Expansionary fiscal policy, government needs to borrow from domestic or foreign sources, draw upon its foreign exchange reserves or print an equivalent amount of money. On a broad generalisation, excessive printing of money leads to inflation. If the government borrows too much from abroad it leads to a debt crisis. If it draws down on its foreign exchange reserves, a balance of payments crisis may arise. Excessive domestic borrowing by the government may lead to higher real interest rates and the domestic private sector being unable to access funds resulting in the crowding out of private investment. Sometimes a combination of these can occur. In any case, the impact of a large deficit on long run growth and economic well-being is negative. Therefore, it is not prudent for a government to run an unduly large deficit.

However, in case of developing countries, where the need for infrastructure and social investments may be substantial, running surpluses at the cost of long-term growth might also not be wise. The challenge then for most developing country governments is to meet infrastructure and social needs while managing the government’s finances in a way that the deficit or the accumulating debt burden is not too great.