Microsoft Word - Money, Banking, and Int Finance(scribd).docx

Money, Banking, and International Finance

High Information Costs Low Information Costs

Figure 3. Impact of information costs on the bond markets

Taxes and Bond Prices

Taxes can cause bond prices and interest rates to differ. For example, the U.S. government
bonds have a lower risk of default and higher liquidity than municipal bonds, whereas
municipal bonds are the state and local government bonds. However, the interest rates of
municipal bonds are consistently lower than U.S. government bonds for the last 50 years
because investors do not pay U.S. taxes on the interest they earn on municipal bonds while they
pay U.S. government taxes on U.S. government securities. If you bought municipal bonds,
subsequently, you would earn a lower interest than U.S. government securities. Nevertheless,
you pay no taxes, compensating you for the greater risk and lower liquidity.
Demand and supply analysis shows the impact of taxes on the bond markets in Figure 4.
Government taxes both the municipal and non-municipal bonds while the default risk, liquidity,
and information costs are equivalent for both markets. Consequently, bond market prices have
the same market price, P* and pay identical interest rates.
U.S. Government has exempted municipal bonds from federal taxes. Thus, investors are
attracted to municipal bonds, boosting their demand, increasing the market price and decreasing
the market interest rate. On the other hand, the taxed bonds are not as attractive as an
investment, so investors buy fewer bonds, causing bond prices to fall and interest rates to rise.
Therefore, municipal bonds have a lower interest rate than U.S. government bonds.

Term Structure of Interest Rates

Term structure of interest rates is the interest rates differ by maturity if the securities have
identical risk, same liquidity, similar information costs, and the same taxes. Economists define