Monetary policy, in the broadest sense, includes all the tools enforced by the government to control the quantity of money in the economy. The quantity of money or the supply of money then affects the overall price level, exchange and interest rates, unemployment rate, and level of output. According to the Case and Fair (2007), U.S. monetary policy is formally set by the Federal Open Market Committee (FOMC), which sets goals concerning the money supply and interest rates as it directs the Open Market Desk in the New York Federal Reserve Bank to buy and/or sell government securities or debt and equity instruments. The capital market then is a market for securities where the government can raise long-term funds to finance its own projects usually regulated by the U.S. Securities and Exchange Commission (SEC) to protect investors mainly against fraud.
To give a quick summary of how monetary supply directly affects output or income, assume that there is an excess supply of money in the market. This will lead households, firms and buy bonds with their extra money so that it earns interest. This however will put downward pressure on the interest rate because many people will be investing their money in interest earning instruments. Investors, on the other hand, borrow money from the banks with the very same interest rate that households and firms determine. A low interest rate means more incentive for investors to borrow and put up their own businesses using their low-interest borrowings from banks. This, in conclusion, increases output and, in the long-run, stimulates output growth.
According to Mankiw (2007), in recent years, the Fed has used the federal funds rate as its short-term policy instrument and when the FOMC meets every six weeks to set its monetary policy, it votes on a target for its interest rate and then directs the Fed Bond traders in New