What does crowding out refer to in fiscal policy?

Crowding out in fiscal policy refers to the phenomenon where increased government spending leads to a reduction in private sector investment. This occurs because when the government borrows funds to finance its spending, it typically competes for available credit in the financial markets. As the government takes on more debt, interest rates can rise due to the higher demand for loanable funds. When interest rates increase, borrowing costs for businesses also rise, which can discourage them from taking out loans for investment projects. As a result, the initial government spending intended to stimulate economic activity may inadvertently lead to less private investment, thereby "crowding out" private sector activities. This concept highlights the potential negative consequences of fiscal policy when government borrowing impacts the financing landscape for private firms.