Explanation

The real default-free interest rate (often approximated by real government bond yields) is influenced by:

1. Expected GDP growth rate - Higher expected economic growth typically leads to higher real interest rates because:

• Increased investment opportunities
• Higher demand for capital
• Potential for higher returns

2. Expected volatility of GDP growth - Higher economic volatility (risk) typically requires higher real interest rates because:

• Investors demand compensation for economic uncertainty
• Higher risk premium for holding long-term assets
• Increased precautionary savings behavior

Correct Answer: C - Both factors contribute positively to real interest rates. Higher growth creates demand for capital, while higher volatility creates risk that must be compensated.