Interest payments on municipal bonds

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Interest payments on municipal bonds are exempt from income taxes, while interest payments on Treasury bonds are subject to income taxes.

(1) Use supply and demand analysis to show the impact of different tax treatments on interest rates of municipal bonds and Treasury bonds. Which bonds have lower interest rates?

(2) If the federal government guarantees today that it will pay creditors if municipal governments default on their payments, on the plot in part (1), graphically show the impact of this action. What is the impact of this action on the size of risk premium?

(3) If the income tax exemption on municipal bonds were abolished, what would happen to the interest rates on these bonds?

Reference no: EM132401255

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