Question

2. (a) If the U.S. government raises the income tax rates, would this have any impact on a state government's bonds? Please explain your answer.

(b) If the expectations theory of the term structure is correct, would a reduction in the supply of thirty-year Treasury bonds affect their yields?

Answer 1

2- Answer: Yes, if the U.S. government raises income tax rates, demand for municipal bonds whichare federal income tax exempt would increase. This would lower the interest rate on the municipal bonds thus lowering the cost to the state of borrowing funds.

B) Answer: The yield curve should have a steep upward slope. Nominal interest rates will increase if the inflation rate increases, therefore, bond purchasers will require a higher term premium to hold the riskier long-term bond.