What does 'crowding out' mean in economic terms?

Crowding out refers to a situation in which increased government spending leads to a decrease in private sector investment. This typically occurs because when the government raises funds, often through borrowing, it can lead to higher interest rates. As interest rates rise, it becomes more expensive for businesses to borrow money for investment. Consequently, private investment may decline as firms opt to scale back or delay their projects due to the higher costs. This dynamic illustrates how government actions in the economy can impact the private sector, particularly in terms of capital availability and investment decisions.

Understanding this concept is critical as it helps analyze the potential trade-offs inherent in fiscal policy. While government spending can stimulate economic activity, especially during downturns, it also has the potential to restrict private sector growth if it leads to crowding out.