Crowding out occurs when an increase in government spending affects the interest rate and investment in what way?

Crowding out is a phenomenon that occurs in the context of government spending and its impact on interest rates and private investment. When the government increases its spending, it often finances this expansion through borrowing. As the government demands more funds in the financial markets, the increased competition for available funds tends to drive up interest rates.

When interest rates rise, the cost of borrowing also increases for private businesses and firms. Higher interest rates make loans for investment projects more expensive, leading many businesses to postpone or scale back their investment activities. This reduction in investment is what we refer to as "crowding out" because it describes the scenario in which government borrowing limits the amount of private investment that can occur.

In this context, an increase in government spending leads to an increase in interest rates and a subsequent decrease in private investment, which aligns with the option chosen. The chain reaction of increased government spending, rising interest rates, and decreased private investment captures the essence of the crowding-out effect in macroeconomic theory.