1. will cause the real interest rate in country B to fall.
2. will cause the real interest rate in country A to fall because capital in A will be less productive.
3. will cause investment in Country B to fall as a result of the fact that capital throughout the world is less productive.
4. will cause all of the above to occur.
Choose the correct option.
Option 1 is the only one that can be true. The increased risk of investing in Country A will cause that country's risk-adjusted investment function to shift downward and, since country A is of significant size, the world investment function (which is the horizontal sum of the two countries' risk-adjusted investment functions) will shift to the left. The interest rate in Country B, which is also the risk-comparable interest rate in Country A, will thus fall. The risk-inclusive interest rate in Country A will rise because the fall in the world interest rate---the risk comparable interest rate in the two countries---will be less than the increase in the risk of investing in country A. Since the interest rate in Country B falls, that country's investment will increase, while investment declines in Country A. If capital was initially flowing from Country B to Country A, the magnitude of that flow declines---if, alternatively, capital was initiall flowing from Country A to Country B, that flow will increase. There will be less world investment, so the quantities of capital employed in the world as a whole will decline---the decline in capital employed in A will more than offset the increase in capital employed in B.