Final answer:
A fall in velocity in the money market diagram is shown as a leftward shift in the money demand curve. This initially creates excess money supply at the original interest rate. The central bank may respond by adjusting the money supply to maintain its target interest rate.
Step-by-step explanation:
In the money market diagram, a fall in the velocity of money indicates that for each unit of currency, fewer transactions are occurring in the economy. This can be depicted as a leftward shift of the demand curve for money (Md), assuming the supply of money (Ms) is fixed and vertical reflecting central bank policies. At the original target interest rate, this shift would result in an excess supply of money or a lower equilibrium interest rate, theoretically. However, if the central bank is targeting a specific interest rate, they may intervene by reducing the supply of money to maintain the target interest rate. The interventions by the central bank to adjust the money supply in order to sustain the target interest rate can be illustrated by the vertical money supply curve shifting leftward in response to changes in money demand.
It is worth noting the discussion on the velocity of money in the U.S. economy and its variability since the early 1980s. Innovations in banking and finance, like the growth of electronic payments and credit card usage, have affected how money is used, making M1 more variable. These changes and the preference of economists for M2 over M1 as a measure reflect the complexities in linking velocity and money supply to the actual economic transactions happening in the market.