Final Answer:
a. If there's a fall in velocity, it will shift the Money Demand (Md) curve to the left, reducing the equilibrium interest rate.
b. This will lead to lower overall economic activity and potentially prompt monetary policy adjustments.
Explanation:
When velocity decreases, it reflects a slowdown in the rate at which money circulates in the economy for transactions. In the money market diagram, a fall in velocity causes a leftward shift of the Money Demand (Md) curve. This shift occurs because at any given interest rate, people require less money for transactions due to the reduced speed at which money changes hands. Consequently, the equilibrium in the money market will be reached at a lower interest rate.
As a result of this decrease in velocity shifting the Md curve leftward, the equilibrium interest rate decreases. Lower interest rates mean that borrowing becomes cheaper, which could encourage increased investment and consumption. However, it might also imply a decrease in the opportunity cost of holding money, potentially leading to a higher demand for goods and services. Central banks might respond by adjusting monetary policy to counteract the impact of this reduced velocity. They may choose to expand the money supply to stimulate economic activity by further lowering interest rates or engaging in other monetary policy tools.
Overall, a fall in velocity affects the money market equilibrium by reducing the demand for money, leading to a lower equilibrium interest rate. This change could prompt policy responses to maintain economic stability.