Final answer:
Crowding out occurs when an expansionary fiscal policy leads to higher interest rates and reduced private investment, making the policy less effective. The central bank may counteract this with expansionary monetary policy if the economy is well below potential GDP.
Step-by-step explanation:
Crowding out makes expansionary fiscal policy less effective because of higher interest rates and less private investment. When the government increases its spending and reduces taxes to boost the economy, this can lead to higher interest rates. Higher interest rates, in turn, discourage firms and households from borrowing, which can lead to a reduction in private investment and household consumption. This phenomena undermines the intended stimulative impact of the expansionary fiscal policy.
However, it's worth noting that if budget deficits are increasing aggregate demand when the economy is substantially below potential GDP, the central bank might engage in expansionary monetary policy to counteract the higher interest rates from government borrowing. This could balance the effects of crowding out, keeping interest rates lower and not deterring private investment as much.