An excess supply of money is created at the initial 5% interest rate. Households and firms sell bonds, decreasing the price of existing bonds and, thereby, increasing their yield. Yield will continue to rise until equilibrium is restored in the money market at an interest rate of 7%.

Solution and Explanation:

Suppose the money market is intially in equilibrium at an equilibrium interest rate of 5% and the quantity of money is $5 million.

An increase in the level of prices in the economy would lead to an increase in the demand for money, which would shift the money demand curve upwards to the right.

This is beacuse people would need a huge amount of money to survive the inflation in the economy.

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Thus, they would sell thier bonds in the market to get the cash. This would decraese the demand forbonds leading a decrease in price of bonds in the market.

To make the bonds attractive again, firms would increase the ineterst rate provided on these bonds. Yields will continue to increase until it reaches a level of 7% and restores the equilibrium level in the money market.

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