What typically happens when the government increases spending?

When the government increases spending, it typically leads to a rise in interest rates. This phenomenon can be explained through the interaction between government borrowing and the supply of money in the economy. When the government spends more, especially if it borrows to finance this spending, it tends to issue more government bonds. To attract investors to buy these bonds, the government may need to offer higher interest rates.

As the government competes with the private sector for available funds, the increased demand for capital can lead to higher borrowing costs across the economy. This scenario is well captured in the concept of "crowding out," where government borrowing can lead to a reduction in private investment as higher interest rates make it more expensive for businesses to borrow money for investment purposes.

The other options do not align with the typical economic response to increased government spending. For example, inflation can increase rather than decrease, and private sector investment may not consistently increase, as it is influenced by various factors, including interest rates and economic conditions. Economic output does not consistently decline; rather, it can rise in the short term due to increased demand from government spending.