What does "crowding out" mean in the context of fiscal policy?

In the context of fiscal policy, "crowding out" refers to a situation where increased government borrowing leads to a decrease in private sector investment. When the government opts to finance its spending through borrowing, it often does so by issuing bonds. This increased demand for funds can raise interest rates, making borrowing more expensive for businesses and individuals in the private sector. As a result, private investments may decline because potential investors find it less attractive to borrow at higher rates, which can ultimately dampen economic growth in the long run.

The correct answer highlights the relationship between government fiscal actions and their unintended consequences on private economic activities. Understanding this concept is crucial as it underscores the potential limitations of using fiscal policy to spur economic growth, especially when government intervention distorts the financial environment for private investors.