What is meant by the term crowding out?

The term crowding out refers to a phenomenon where increased governmental spending leads to higher interest rates, which in turn discourages private investment. When the government borrows funds to finance its spending, it competes for the same pool of available investment capital in the financial markets. As demand for funds increases due to government borrowing, interest rates are driven up.

Higher interest rates make borrowing more expensive for consumers and businesses, which can reduce the amount of private investment in the economy. Therefore, while government spending can initially promote economic activity, if it leads to significantly higher interest rates, the subsequent decrease in private investment can offset the benefits of the government spending. This concept is crucial in understanding the interplay between government fiscal policies and private sector economic activities, particularly the balance and potential trade-offs involved.