7. Global flight to quality

In the autumn of 2008, investors, concerned about liquidity in debt markets around the world, fled markets deemed risky into markets that offered greater liquidity. The flight to liquidity can be seen in the interest rate spread between 3-month Treasury bills and 20-year Treasury bonds.

The following two graphs show the loanable funds markets for 20-year Treasury bonds and 3-month T-bills.

Adjust the following graph to show the effect of the flight to quality on the loanable funds market for 20-year Treasury bonds.

Loanable Funds Market for 20-year Treasury BondsDemand for LFSupply of LFINTEREST RATE ON BONDSQUANTITYDemand for LF Supply of LF

Adjust the following graph to show the effect of the flight to quality on the loanable funds market for 3-month Treasury bills.

Loanable Funds Market for 3-month T-billsDemand for T-billsSupply of T-billsINTEREST RATE ON T-billsQUANTITYDemand for T-bills Supply of T-bills

Complete the following statement.

As a result of this flight to liquidity, the interest rate in the 20-year Treasury bonds market , while the interest rate in the T-bill market . Consequently, the default risk premium spread .