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1 Introductory concepts 2  Market mechanism  3 Elasticities  4 Market structures 5  Market failures  6  Macro economic activity/eco growth  7 Inflation 8  Employment & unemployment  9  External Stability  10  Income distribution 11.Factors affecting economy  12  Fiscal/Budgetary policy  13  Monetary Policy   14 Aggregate Supply Policies  15 The Policy Mix

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Expansionary or contractionary Budgets

The table below provides a 'general rule of thumb' to help one determine whether a budget is expansionary or contractionary.   

While the table provides a good starting point from which to analyse the nature and impact of a budget, there are a number of possible exceptions to the general rule.  

To determine whether a budget is likely to expand or contract economic activity, it is important to do three things.

  1. Examine the actual size of the outcome itself to determine its likely impact on the economy.  A Deficit is generally considered expansionary because the government is injecting more money into the economy than it is extracting.  Conversely, it is generally contractionary if there is a surplus because the government is extracting more funds from the economy than it is injecting.  

  1. Examine the movement of the budget outcome over two or more years to determine the setting or stance of policy.  For example, a reduction in the size of a deficit generally indicates a less expansionary budgetary policy setting or stance and a reduction in the size of the surplus indicates a less contractionary stance.

  1. Examine the changing composition or structure of the budget itself.  For example, in isolation, the replacement of $1B of foreign aid with $1Bm on infrastructure is expansionary, even though it will have no impact on the size of the budget deficit or surplus.  Similarly, any changes to the precise nature of government spending within the budget can impact on the degree to which it expands or contracts the economy 'over time'.  For example, replacing recurrent expenditure (e.g. spending on welfare) with Investment expenditure (e.g. spending on infrastructure) will tend to be less expansionary in the short term but more expansionary in the long term.

The cyclical and structural components of the budget and the impact on Budgetary policy settings

Remember from the section on automatic and discretionary stabilisers  that a change in the budget outcome can occur automatically, without any change in policy (i.e. via automatic stabilisers) or via a deliberate change in policy (i.e. via discretionary stabilisers).  It is these deliberate changes to policy (which involves a change to the composition or structure of the budget) that are the real key to determining whether the government intends the budget to have an expansionary or contractionary impact on the level of economic activity.  In this respect, economists will sometimes refer to the change in the structural budget outcome when determining whether a budget is intended to expand or contract the economy.  This means that a bigger surplus can actually be consistent with the delivery of an expansionary BP stance and a bigger deficit can be consistent with the delivery of an contractionary BP stance. For example, strong rates of economic growth may have led to a large automatic  increase in the surplus (let’s say from $20B to $30B)  However, if the government decided to introduce structural net spending initiatives worth $5B, it would result in a final outcome of $25B surplus. While the surplus is bigger (increasing from $20B to $25B), the structural surplus has fallen by $5B and it would generally be considered to be an expansionary budget (or a less contractionary one).

Can a surplus be expansionary

Following on from the previous discussion, it is clear that the existence of surplus does not mean that a particular budget is always contractionary. However, even the delivery of a structural surplus is considered by some economists to be expansionary (or have expansionary effects) over the longer term. This is because a surplus means that the government becomes a net lender for that year (rather than a borrower) and this leads to less pressure on funds in financial markets.  This should then lead to some reduction in interest rates (and/or exchange rates), which increases Consumption, Investment, (net exports), AD and economic growth.  This is sometimes referred to as the 'crowding in' argument (or the opposite of the 'crowding out' argument related to budget deficits).  In addition, some would argue that reduced deficits (or increased surpluses) could be evidence of the government interfering less in the operation of the free market (e.g. less subsidies, less expenditure on regulation, etc.) which further encourages an increase in private sector Investment.  Other ways that a surplus could be beneficial for the economy are covered on in the section ‘Rationale for budget surpluses’ on the next page.

Can a deficit be contractionary?

Those economists who argue that a surplus can be expansionary over time will also argue that a deficit can be contractionary in the long term.  This time, the deficit leads to 'crowding out' of the private sector, as the increased borrowing by the government exerts upward pressure on interest rates (and/or exchange rates), which then reduces AD and economic growth.  


In addition to the cost of financing budget deficits and the crowding out problem, budget deficits lead to a build-up of government debt over time.  This creates additional problems for governments in terms of the impact on government credit ratings, which if downgraded leads to higher borrowing costs and an even bigger deficit.  Further, deficits must eventually be reigned in over time, which may involve future restraint in the form of higher taxes and lower government spending (unless the next boom delivers these outcomes automatically), which then have negative consequences for economic and employment growth.  Accordingly, to avoid future pain, governments need to achieve the right balance by delivering deficits that do just enough to fill the void in the economy when recession (or contraction) arrives, without imposing too big a burden on taxpayers and the economy in the future.  

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