What is meant by the term "crowding out" in fiscal policy?

The term "crowding out" in fiscal policy refers specifically to the phenomenon where increased government borrowing leads to higher interest rates, which in turn reduces private sector investment. When a government increases its spending and finances it through borrowing, it competes for available funds in the financial markets. This demand for funds can push interest rates higher, as lenders require greater returns for their loans due to the increased risk associated with higher government debt levels.

As interest rates rise, borrowing costs for private businesses and consumers also increase. Consequently, private sector investment may decline because businesses often face higher costs when seeking loans to finance expansion or new projects. This effect can negate or diminish the stimulating impact that the initial government spending aimed to achieve in the economy. Thus, the concept of crowding out highlights a potential downside of expansive fiscal policy when it leads to unintended consequences for private investment.