Suppose the Fed cares only about keeping the economy close to full-employment output

The Fed can target the real money supply (thus keeping the LM curve fixed) or it can target the real interest rate, changing the money supply and shifting the LM curve however is necessary to prevent a change in the real interest rate. (a) Which is the best policy if the main shocks to the economy are shocks to the IS curve? Explain why. Illustrate with a diagram. (b) Which is the best policy if the main shocks to the economy are shocks to real money demand? Explain why. Illustrate with a diagram.

(a) Target the real money supply, since targeting r would lead to larger fluctuations in output.
(b) Target the real interest rate to offset shocks to money demand and stabilize output.