Introduction

Fiscal policy deals with the taxation and expenditure decisions of government. Monetary policy deals with the supply of money in the economy and the rate of interest. These are the main policy approaches used by economic managers to steer the economy. In most modern economies, the government deals with fiscal policy while the central bank is responsible for monetary policy. Fiscal policy is composed of several parts. These include tax policy, expenditure policy, investment or disinvestment strategies, and debt or surplus management. Fiscal policy is an important constituent of the overall economic framework of a country and is intimately linked with its general economic strategy.

Fiscal policy also feeds into economic trends and influences monetary policy. When the government receives more than it spends, it has a surplus. If the government spends more than it receives, it runs a deficit. To meet the additional expenditures, it needs to borrow from domestic or foreign sources, draw upon its foreign exchange reserves or print an equivalent amount of money. This tends to influence other economic variables. On a broad generalization, excessive printing of money leads to inflation. If the government borrows too much from abroad, an external shock (such as an exchange rate depreciation or inability to roll over the debt due to perceived lack of ability to repay) may lead to a debt crisis. If it draws down on its foreign exchange reserves, a balance of payments (BoPs) 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, there is broad agreement that 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, it is sometimes argued that running surpluses at the cost of long-term growth might also not be wise (Fischer and Easterly, 1990).