# R10 | google/gemini-3.6-flash | run 2

## Prompt

What causes inflation, and what tools do central banks use to control it? Summarize and cite authoritative sources.

## Response

Inflation is primarily caused by imbalances between aggregate demand and supply, sudden spikes in production costs, rapid expansion of the money supply, and rising public inflation expectations [IMF Economics Guide](https://www.imf.org). Central banks control inflation by implementing restrictive monetary policy tools that increase borrowing costs, reduce liquidity in the financial system, and anchor long-term price expectations [Federal Reserve Monetary Policy](https://www.federalreserve.gov).

## Causes of Inflation

Inflation represents a broad rise in the price level of goods and services over time, leading to a decline in currency purchasing power [IMF Economics Guide](https://www.imf.org). Economists categorize the primary drivers of inflation into demand-side, supply-side, monetary, and expectational factors [San Francisco Fed](https://www.frbsf.org).

**Demand-Pull Inflation**
Demand-pull inflation occurs when aggregate demand for goods and services outpaces an economy's productive capacity [Cleveland Fed Analysis](https://www.clevelandfed.org). When consumer confidence, government spending, or private credit surges, buyers bid up prices for limited available output [Cleveland Fed Analysis](https://www.clevelandfed.org).

**Cost-Push Inflation**
Cost-push inflation occurs when production expenses rise due to supply disruptions, wage hikes, or increased raw material and energy costs [San Francisco Fed](https://www.frbsf.org). Higher operating costs contract aggregate supply, forcing businesses to raise consumer prices to maintain operating margins [San Francisco Fed](https://www.frbsf.org).

**Monetary Inflation**
Monetary inflation results from excess money supply growth relative to the real productive output of the economy [IMF Economics Guide](https://www.imf.org). When central banks expand credit or purchase assets rapidly over extended periods, the purchasing value of each individual currency unit diminishes [IMF Economics Guide](https://www.imf.org).

**Built-In Inflation and Expectations**
Built-in inflation develops when households and businesses expect higher inflation to persist [Cleveland Fed Analysis](https://www.clevelandfed.org). Workers demand higher wages to preserve real income, and firms raise prices to cover labor costs, creating a self-reinforcing wage-price spiral [Cleveland Fed Analysis](https://www.clevelandfed.org).

| Inflation Type | Primary Cause | Common Triggers | Impact on the Economy |
| :--- | :--- | :--- | :--- |
| **Demand-Pull** | Demand outstrips aggregate supply | Stimulus spending, low interest rates, strong hiring | Drives price levels up as capacity limits are reached |
| **Cost-Push** | Supply shocks increase input costs | Geopolitical conflict, energy spikes, supply chain bottlenecks | Reduces output while raising prices; risks stagflation |
| **Monetary** | Money supply grows faster than output | Sustained asset purchases, rapid credit expansion | Devalues purchasing power across all market sectors |
| **Built-In** | Elevated forward inflation expectations | Persistent past inflation, unanchored expectations | Prompts wage-price spirals that entrench price increases |

## Central Bank Tools to Control Inflation

Central banks maintain price stability by targeting low, predictable inflation rates—typically around 2 percent annually [Federal Reserve Monetary Policy](https://www.federalreserve.gov). When inflation exceeds target levels, central banks tighten monetary policy using several key operational tools [Federal Reserve Monetary Policy](https://www.federalreserve.gov).

| Policy Tool | Operational Mechanism | Inflation Control Mechanism |
| :--- | :--- | :--- |
| **Policy Interest Rates** | Raising target policy rates (such as the Federal Funds Rate) increases short-term interbank borrowing costs [Federal Reserve Monetary Policy](https://www.federalreserve.gov) | Raises consumer and commercial borrowing costs (mortgages, business loans), cooling overall economic demand |
| **Interest on Reserve Balances** | Adjusting the rate paid to commercial banks on reserves held at the central bank [Federal Reserve Monetary Policy](https://www.federalreserve.gov) | Encourages banks to keep excess liquidity parked at the central bank rather than issuing private market loans |
| **Balance Sheet Reduction (QT)** | Selling Treasury bonds or letting holdings mature without reinvestment (Quantitative Tightening) [Federal Reserve Monetary Policy](https://www.federalreserve.gov) | Removes liquidity from financial markets, putting upward pressure on long-term interest rates |
| **Reserve Requirements** | Mandating the minimum percentage of deposits commercial banks must keep in reserve [Federal Reserve Monetary Policy](https://www.federalreserve.gov) | Restricts the volume of money commercial institutions can lend out into the real economy |
| **Forward Guidance** | Publicly communicating intended future monetary policy trajectories [Cleveland Fed Analysis](https://www.clevelandfed.org) | Shapes public expectations, guiding long-term market rates and anchoring wage-setting behavior |

By coordinating these monetary policy tools, central banks aim to slow spending and realign aggregate demand with supply without causing severe economic downturns [Federal Reserve Monetary Policy](https://www.federalreserve.gov).

Would you like to explore how fiscal policy and government spending decisions interact with monetary policy during periods of high inflation?
