Final answer:
In a situation where government borrowing increases, causing a larger increase in debt in 2021 than in 2020 with a zero nominal interest rate, the investment would likely fall, and the real interest rate would rise due to the 'crowding out' effect, where government borrowing competes with private borrowing.Option B is the correct answer.
Step-by-step explanation:
The question is addressing the impact of changes in government borrowing on the equilibrium in the financial market, specifically how it affects the real interest rate and investment. According to Figure 18.8 presented, an increase in government borrowing shifts the demand curve for financial capital to the right, leading to a rise in the equilibrium interest rate (from E₀ to E₁) and a higher interest rate overall. Consequently, this increase in the interest rate can 'crowd out' private investment, meaning that private investments may decline as the cost of borrowing increases.
This crowding out effect is a result of the government borrowing competing with private borrowing, causing foreign investors' enthusiasm to diminish and leading to higher interest rates and lower quantity of financial investment for the private sector.
Coming back to the scenario where a country has a larger increase in debt in 2021 than it had in 2020 with a nominal interest rate of zero for both years, this would likely lead to a scenario described by option 'b': Investment falls and the real interest rate rises. The increase in debt suggests that the government borrowing has increased, which shifts the demand curve for financial capital to the right, raising the real interest rate and crowding out some private investment.