Tax-exempt interest is interest that is not subject to federal income tax. Income earned from bonds issued by states, cities, counties or the District of Columbia is tax-exempt.
The interest earned on U.S. Treasury bonds is tax-exempt only at the state level. On your federal return these earnings are subject to tax.
On the other hand, interest on municipal bonds is tax-exempt on your federal taxes and in the state in which you reside as long as it was also the state in which the bond was issued. It is subject to taxes in all the other states, though.