Question

1- If the income tax exemption on municipal bonds were abolished, show what would happen to the interest rates on these bonds. Show and explain the effects would the change have on interest rates on U.S. Treasury securities?(draw graphs)

2-Suppose you are in charge of the financial department of your company and you have to decide whether to borrow short or long term. Checking the news, you realize that the government is about to engage in a major infrastructure plan in the near future. Predict what will happen to interest rates. Will you advise borrowing short or long term?

Answer 1

(1)

Abolishion of tax exemption on Muni-bonds will decrease the demand for Muni-bonds. The Muni-bond demand curve shifts to left, decreasing both price and quantity of bonds. Bond price and interest rate being inversely related, lower bond price increases interest rate.

In following graph, D0 and S0 are initial bond demand and supply curves, intersecting at point A with initial price P0 and quantity of bonds Q0. When D0 shifts left to D1, it intersects S0 at point B with lower price P1 and lower quantity Q1.

Lower attractiveness of Muni-bonds will increase the demand for Treasury bonds, its substitute. The treasury-bond demand curve shifts to right, increasing both price and quantity of treasury bonds. Bond price and interest rate being inversely related, higher bond price decreases interest rate.

In following graph, D0 and S0 are initial bond demand and supply curves, intersecting at point A with initial price P0 and quantity of bonds Q0. When D0 shifts right to D1, it intersects S0 at point B with higher price P1 and higher quantity Q1.

(2)

To finance the infrastructure expense, government is likely to increase borrowing. Higher government borrowing will increase market interest rate in short run.

However, in long run, the short-term increase in interest rate will smoothen out and interest rates will fall in long run. Therefore, I advice long-term borrowing since long-term interest rate (cost of borrowing) will be lower.