# R10 | anthropic/claude-opus-5 | run 2

## Prompt

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

## Response

Inflation is a sustained, economy-wide rise in prices — not an increase in the cost of one or several products, but a general increase in the overall price level of goods and services. Its short-run drivers include demand surges and supply shocks, while sustained inflation is tied to money and credit growth outpacing the economy's productive capacity. Central banks counter it primarily by raising policy interest rates, supported by balance-sheet operations and communication that anchors expectations.

## Main Causes

**Demand-pull pressure.** Too much spending chasing too few goods — when total demand for goods and services exceeds what available resources can supply — pushes prices up. Rising incomes or lower borrowing costs both create greater demand; cheap credit makes financing houses, appliances, and cars less expensive, encouraging more borrowing ([Cleveland Fed](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation)).

**Excess money growth.** Several things can lead to inflation in the short run, but long-run sustained inflation is caused by excessive growth in the money supply ([Fed Education](https://www.federalreserveeducation.org/teaching-resources/economics/inflation/inflation-fed-and-you)). If the money supply grows faster than the economy's ability to produce goods and services, inflation will result ([St. Louis Fed](https://www.stlouisfed.org/education/feducation-video-series/money-and-inflation-explained)).

**Cost-push and supply shocks.** An "inflation shock" — such as the 1973 oil embargo, which caused a dramatic rise in oil prices — spreads through the economy because so much of it depends on oil-based products. In the 1970s these shocks combined with excess money growth and overly accommodative policy to fuel inflation through the decade.

**Expectations.** Inflation is also affected by what people expect it to be, because they make decisions based partly on those beliefs. Stanford economist John Taylor argues inflation rises when the Fed sets too low an interest rate or when money supply growth is too rapid ([Stanford Report](https://news.stanford.edu/stories/2022/09/what-causes-inflation)).

**Policy stance itself.** Taylor identifies an unusually low real interest rate driven by monetary policy as a key reason for the higher inflation rate of the early 2020s.

## The Central Bank Toolkit

| Tool | How it works | Notes |
|---|---|---|
| Policy interest rate | The federal funds rate is the Fed's primary tool; changes influence other rates and thus household and business borrowing costs | Raised when inflation is too high to slow the economy |
| Open market operations | Purchases and sales of government securities, outright or via repos, adjust the quantity of bank reserves | In ample-reserve regimes, used to manage balance-sheet size rather than the daily policy rate |
| Administered rates on reserves | After 2008, the Fed and ECB moved to "ample reserve" systems where the rate paid on reserves became the primary control instrument | Sets the policy stance directly |
| Reserve requirements | Set minimum bank holdings | Largely de-emphasized in modern frameworks |
| Asset purchases (QE/QT) | Compress term premia at the zero lower bound | Used when the funds rate is near zero and other tools are needed |
| Forward guidance | Shapes expectations of the future rate path | Credibility matters: if the public believes the bank will manage inflation, behavior aligns and policy becomes more effective |

## Targets and TransmissionInflation targeting is a form of monetary policy in which the central bank changes interest rates to influence aggregate demand and keep the economy near an inflation target, normally specified by the government ([CORE Econ](https://books.core-econ.org/the-economy/macroeconomics/05-macroeconomic-policy-09-inflation-targeting.html)). In the US, the FOMC sees 2 percent as the right amount of inflation and uses annual changes in the personal consumption expenditures (PCE) price index as its preferred measure.

Transmission runs through financial conditions: when rates fall, borrowing is cheaper, households buy more and firms invest and hire, and stronger demand can push wages and other costs higher. Tightening reverses this chain. The Taylor principle prescribes that policy rates move more than one-for-one with inflation, so real rates rise when inflation rises.

## Key Constraints

- **Time lags and forecast error.** Policy effects arrive with a delay, so central banks act on projections rather than current data ([Fed](https://www.federalreserve.gov/faqs/money_12856.htm)).
- **Limited control.** Many factors affect inflation and employment beyond monetary policy.
- **Stagflation dilemma.** It is hard to address with usual tools: raising rates to curb inflation can further suppress growth and raise unemployment, while cutting rates risks pushing inflation higher.
- **Mandate tradeoffs.** The Fed weighs risks to both inflation and employment under its dual mandate of maximum employment and price stability.
- **Fiscal policy interacts.** Government tax and spending decisions also shape growth and inflation, operating outside central bank control.

Would you like a deeper look at how quantitative tightening differs from rate hikes in bringing inflation down?
