Question

If the tax-exempt status of municipal bonds were abolished, how would the interest rate on these bonds change? How would the interest rate on US treasury bonds change? Use graphs to explain the changes in both markets

Answer 1

In each graph, Bond price (P) and quantity of bond (Q) are measured vertically and horizontally, respectively. D0 & S0 are initial demand & supply curves, intersecting at point A with initial bond price P0 & quantity of bonds Q0.

(a) If municipal bonds (which are currently tax-exempt) becomes taxable, interest received on these bonds will become taxable and opportunity cost of holding Muni-bonds will increase. Therefore, investors will decrease their demand for Muni-bonds, shifting their demand curve leftward and lowering both bond price and quantity of bonds. As bond price falls, interest rate on Muni-bonds rises (Since bond price and interest rate are inversely related).

In following graph, as demand shifts left to D1, it intersects S0 at point B with lower price P1 and lower quantity Q1.

(b) US treasury Bonds (T-Bonds) and Muni-bond are substitutes. Therefore, investors will increase their demand for T-bonds, shifting their demand curve rightward and increasing both bond price and quantity of bonds. As bond price rises, interest rate on T-bonds falls (Since bond price and interest rate are inversely related).

In following graph, as demand shifts right to D1, it intersects S0 at point B with higher price P1 and higher quantity Q1.