What is crowding out in economic terms?

Crowding out refers to a situation where government spending leads to a reduction in private sector investment. This typically occurs when the government borrows money to finance its expenditures, which can lead to higher interest rates. As the government competes with the private sector for available loanable funds, the increased demand for credit can drive up interest rates. When interest rates rise, the cost of borrowing becomes more expensive for businesses and individuals, which can deter them from making investments in capital projects, new ventures, or other economic activities.

Thus, the correct answer highlights the relationship between government borrowing, rising interest rates, and the consequent decrease in private investment. This concept is significant in macroeconomic theory as it illustrates the potential trade-offs between government spending and private sector growth, showing how fiscal policy can sometimes have unintended negative effects on the economy.