The V and Q are fixed so that any change in M causes a proportionate change in P. To control P, it is therefore necessary that M be brought under control. Any policy with respect to this is known as monetary policy.
Amongst various instruments available with central bank are interest rates, reserve requirements, interventions in the credit market and so on. These instruments are used to influence the demand for liquidity and, thus, M could be controlled.
In fact, Federal Reserve uses several policy instruments to reduce the adverse effects of fluctuations in income. An important instrument used to influence money supply is interest rate, which is signaled by Federal Rate. In the transaction motive for money, there is an inverse relationship between opportunity cost of money that is interest rate and demand for liquidity. As such, if Federal targets inflation, it would have to increase interest rate so that liquidity is removed from the system. Any increase in interest rate would induce people to part away liquidity and thereby bring about stability in the price level.
Second mechanism operates through credit market. It is assumed that borrowing from credit market finances entire investment spending. Credit expansion is an important mechanism for money creation; thus, if credit expansion is controlled, money supply can be controlled and so price could be controlled. Federal could use interest rate directly to influence credit creation.
A necessary and sufficient condition for investment to take place is that marginal efficiency of capital, measured by rate of return, should be at least or equal to cost of capital, given by interest rate. With every increase in Federal rate, the Federal Reserve indirectly increases cost of capital such that the basic condition for investment spending gets violated. This reduces incentives for private investment resulting is lack demand for credit. Similarly, if the economy has slowed down, they could reduce