For many years, state and local governments borrowed funds to finance capital projects (prisons, parks, roads, etc.) by issuing tax-free bonds. These bonds have attracted lenders by offering interest payments that are free from federal and local income taxation. The federal government recently introduced an alternative taxable bond program—“Build America Bonds”—which provides a 35 percent subsidy to states and municipalities for the interest they pay on the bonds they issue but requires bondholders to pay taxes on all of the interest they receive.

Using a supply and demand diagram, show how—if at all—this change in policy will affect the amount of money borrowed by municipalities and the after-tax interest rate received by bondholders.