I went to the help section of Windows Movie Maker. It said that the recomended capture setting to either view on the computer, or to edit and record to a video CD is the WMV setting. That is what I originally did. Your recomendation is to capture using the DV-AVI format. That will give me better quality, correct?
Absolutely
DV AVI is the least compressed and for all practical purposes what is on the DV tape. It is possible but very difficult to degrade its PQ by normal editing as it stands up very well to multiple re renders by still maintaining the near original quality.
Also, what is the diference between a video CD and a DVD?
The answer lies in what happens when you've finished editing the AVI.
A Video CD is a video format in which the video ends up on a CD not a DVD. It is popular in the Indian subcontinent, West Africa and the far East where there are VCD players ( which cannot play DVD).
Its IQ is better than VHS but not by much.
DVD is what you are used to here " the sort you get from blockbusters

DVD at best quality will only fill 1 hr at 4.7Gb , unlike Video CD at 700Mb
This means that compared to DVD , the amount of data used to make a VCD is less than 1/5th
As such, VCD video is more compressed.
VCD uses mpeg1 video file format while DVD uses mpeg2 ( much less compressed.
The affordability of DVD blank media and Recording drives means there is no cost advantage in trying to make a VCD whose image quality is far less than with a DVD
Most DVD players
can play a VCD and PCs will usually play them anyway