What does crowding out mean in fiscal policy?

Crowding out refers to a scenario in which increased government spending leads to higher interest rates, which consequently results in a reduction of private sector investment. When the government borrows money to finance its spending, it increases the demand for loanable funds. This heightened demand can drive up interest rates. As borrowing costs rise, it becomes more expensive for businesses and individuals to finance new investments, which can lead to a decrease in private investment.

In this context, the correct answer captures the essence of crowding out in fiscal policy, highlighting the inverse relationship between government spending and private sector investment due to changes in interest rates. This phenomenon is often a significant concern for policymakers, as it can undermine the effectiveness of fiscal stimulus efforts intended to encourage economic growth.