The acronym 'API' stands for 'Application Programming Interface'. An API is crucial because it defines a set of rules and protocols for how software applications communicate with one another. By providing a standardized interface, APIs enable developers to integrate various functionalities and services without having to understand the underlying code. This enhances interoperability and scalability, allowing for the rapid development of applications. APIs play a significant role in modern software ecosystems, facilitating everything from data exchange to payment processing, and they are essential for building flexible and extensible systems.