When the economy is producing its potential output, an increase in government spending must necessarily reduce some component of private spending. This phenomenon is called

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Crowding out is when an increase in government spending leads to a decrease in private spending. This is because when the government borrows money to finance its spending, it increases the demand for loanable funds, raising interest rates and making it more expensive for the private sector to borrow and spend. As a result, private investment and consumption may decrease, leading to a reduction in overall economic activity.

When the Economy Is Producing Its Potential Output, an Increase