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In practice, the Fed conducts monetary policy by targeting the interest rate. In addition, the interest rate the Fed targets depends on the state of the economy. Targeting the Interest RateWe saw in the chapter on Fed policy that when the Fed increases the money supply by buying government securities, the interest rate falls. The opposite occurs when the Fed sells securities--the money supply falls and the interest rate subsequently rises. How much the interest rate changes depends on the shape of the money demand curve.What this means is that the Fed can either pick a money supply target and accept the implied value of the interest rate, or pick an interest rate and accept the money supply change that must occur to achieve that interest rate. In practice, the Fed chooses the interest rate value and accepts the money supply consequence; that is, it targets the interest rate. The Open Market Committee will direct the Open Market desk to buy securities until a particular interest rate value is achieved. An expansionary monetary policy essentially lowers the interest rate. A contractionary monetary policy essentially raises the interest rate.
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