The Ground Rules
The way fiscal policy works is with the following ground rules:
(i) Interest rates cannot be significantly lower than inflation in a stable economy unless the bank works to limit or choke the money supply. Constraining credit or money supply is never good for an economy. But why can’t interest rates be lower you ask? If this happened, people could borrow money supply from the central bank, put in no effort and just buy anything or any commodity. Wait for inflation to increase prices and then sell the commodity and repay the loan with lower than inflation amounts in interest. Voila, you have free profits which dilute money value of the society and would drive more inflation and instability as everybody would prefer this method to working.
(ii) Currency (paper money, even it is not in paper physically) Inflation is driven by and accompanies growth. The growth of an economy comes with the pain of demand pressure on the supply chain. With higher demand and low supply, Economics 101, the price action is upward. But if this happens across all classes, rather than for a particular good as in Ecnomics 101, then it just results in inflation rather than a true price increase relative to other things.
(iii) So let’s say the GDP growth in the US in a given year is 2% and inflation is 1%, then the central bank cannot have a sensbile monetary policy of rates below 1%, as described above. Can the base rate be much above 1%? No, as well. Artificially building in a high cost of capital by a monetary policy of raising interest rates above inflation, hurts economic growth and leads to an incorrect value transfer. The value destruction happens to people and organizations seeking opportunity in the economy and the only gain is of making existing wealth multiply for private holders of existing debt/bonds or for the central bank itself on debt repayment. Even at inflation match rates, this is obviously a central bank issue (but not for private holders as their wealth is real, not “loaned out” by creating money). The issue is on money supply contraction, where a 100$ loan comes back as 101$ with interest and a new loan of 101$ is not demanded by the economy due to lack of demand for money supply. Then the central bank destroys the 100$ of money it created, but gets to keep the 1$. (we are talking much larger numbers of course)
Cars and Physics 