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Subject 2. Default-Free Interest Rates and Economic Growth PDF Download
The average level of real short-term interest rates is positively related to:

  • the trend rate of growth of the underlying economy and
  • the volatility of economic growth in the economy.

An increase in real GDP growth means more goods and services will be available in the future relative to today. It reduces the need for investors to save for future consumption. The opportunity cost of not consuming today will fall and investors will save less and borrow more. In the capital market, less supply (saving) and more demand (borrowing) means the price (the real default-free interest rate) will go up. That is, interest rates are positively related to GDP growth rate.

An increase in the volatility of real GDP growth means there is greater risk that the income for consumption will be lower than expected. Risk-averse investors will require a higher real rate of return in compensation.

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