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Suppose that fear and uncertainty overtake the financial markets, causing investors to sell municipal bonds and flee into the Treasury market. This movement of funds
Suppose that fear and uncertainty overtake the financial markets, causing investors to sell municipal bonds and flee into the Treasury market. This movement of funds from financial instruments with relatively high default risk to financial instruments with lower default risk, caused by investors seeking certainty and stability, is referred to as a flight to quality. The following two graphs show loanable funds market for Treasury bills and municipal bonds. Suppose that initially, there is a difference between the interest rate in the T-bill market and the interest rate in the muni bonds market, called the default risk premium spread. Adjust the following graph to show the effect of the flight to quality on the loanable funds market for municipal bonds. Loanable Funds Market for municipal Bonds Supply of LF Demand for LF Supply of LF INTEREST RATE ON BONDS Demand for LF QUANTITY Adjust the following graph to show the effect of the flight to quality on the loanable funds market for Treasury bills. ? Loanable Funds Market for Treasury Bills Supply of T-bills Demand for T-bills Supply of T-bills INTEREST RATE ON T-bills Demand for T-bills QUANTITY Complete the following statement. while the interest rate in the T-bill market As a result of this flight to quality, the interest rate in the municipal market . Consequently, the default risk premium spread
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