# R10 | perplexity/sonar-pro | run 2

## Prompt

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

## Response

Inflation is driven by a combination of **strong demand**, **constrained supply**, **monetary conditions (money and interest rates)**, and **inflation expectations**, rather than a single cause.[1](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation)[2](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html)[9](https://en.wikipedia.org/wiki/Inflation) Central banks mainly control inflation using **monetary policy tools** such as policy interest rates, balance sheet (asset purchases/sales), and communication that anchors expectations.[4](https://news.stanford.edu/stories/2022/09/what-causes-inflation)[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)  

## Main causes of inflation

**1. Demand-pull inflation (excess demand)**  
When total demand for goods and services exceeds the economy’s sustainable capacity to produce them, firms raise prices, creating **demand‑pull inflation**.[1](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation-basics/what-causes-inflation)[2](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html)[9](https://en.wikipedia.org/wiki/Inflation)  

Key drivers include:  
- Strong household and business spending  
- Expansionary fiscal policy (higher government spending, tax cuts)  
- Easy monetary policy (low interest rates and ample credit) that stimulates borrowing and demand[4](https://news.stanford.edu/stories/2022/09/what-causes-inflation)[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)  

**2. Cost-push inflation (negative supply shocks)**  
Inflation can also arise when the **cost of production rises** or when the supply of goods and services falls, forcing firms to increase prices—known as **cost‑push inflation**.[1](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation)[2](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html)[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)  

Examples:  
- Higher energy, commodity, or shipping costs  
- Supply chain disruptions or production bottlenecks  
- Labor shortages that push up wages  
- Other supply shocks such as natural disasters or geopolitical conflicts[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)[9](https://en.wikipedia.org/wiki/Inflation)  

Recent research on the post‑2020 spike in inflation in the United States finds that **energy price volatility**, **supply‑chain backlogs**, and **auto‑sector price increases** were major contributors.[6](https://www.bls.gov/opub/mlr/2023/beyond-bls/what-caused-inflation-to-spike-after-2020.htm)[8](https://www.richmondfed.org/publications/research/economic_brief/2025/eb_25-20)  

**3. Inflation expectations**

What households, workers, and firms *expect* about future inflation can become self‑fulfilling:  
- If people expect higher inflation, workers push for higher wages and firms raise prices pre‑emptively.  
- If expectations are stable around a central bank’s target (often ~2%), inflation is easier to keep low and predictable.[1](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation)[2](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html)[7](https://hbr.org/2022/12/what-causes-inflation)  

Modern macroeconomics formalizes this in frameworks such as the **Phillips curve with expectations and supply shocks**, where demand conditions, supply shocks, and expectations jointly determine inflation.[9](https://en.wikipedia.org/wiki/Inflation)  

**4. Monetary policy and money supply**

Over longer periods, many economists view **monetary policy** as a key driver of persistent inflation:  
- Sustained **easy monetary policy**—interest rates kept “too low for too long” or money supply growing rapidly—tends to raise inflation.[4](https://news.stanford.edu/stories/2022/09/what-causes-inflation)[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)[9](https://en.wikipedia.org/wiki/Inflation)  
- Stanford economist John Taylor emphasizes that when the central bank sets policy rates significantly below levels implied by rules like the Taylor rule, or allows money supply growth to be too rapid, inflation typically rises.[4](https://news.stanford.edu/stories/2022/09/what-causes-inflation)  

More generally, changes in **money supply**, **interest rates**, and **credit conditions** interact with demand and supply to influence inflation.[3](https://www.reddit.com/r/AskEconomics/comments/1m0segl/what_causes_inflation)[9](https://en.wikipedia.org/wiki/Inflation)  

**5. Other structural factors**

Research and commentary also highlight:  
- Government debt and fiscal expansions that may increase demand and interact with monetary policy.[8](https://www.richmondfed.org/publications/research/economic_brief/2025/eb_25-20)  
- Housing shortages, demographic trends, and climate‑related disruptions as longer‑run drivers of price pressures in certain sectors.[9](https://en.wikipedia.org/wiki/Inflation)  

## Tools central banks use to control inflation

Central banks (like the Federal Reserve, European Central Bank, and others) use **monetary policy** to keep inflation near a target level, typically around 2% per year.[4](https://news.stanford.edu/stories/2022/09/what-causes-inflation)[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)  

### 1. Policy interest rates

The primary tool is the **short‑term policy interest rate** (e.g., the federal funds rate in the U.S.):  
- To **reduce high inflation**, central banks *raise* interest rates. This makes borrowing more expensive, cools demand for houses, cars, and business investment, and slows overall spending.[4](https://news.stanford.edu/stories/2022/09/what-causes-inflation)[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)  
- To **prevent inflation from being too low** (or avoid deflation), they *lower* rates, encouraging borrowing and spending.  

According to John Taylor and many others, **raising interest rates sufficiently when inflation rises** is critical to bringing inflation back to target.[4](https://news.stanford.edu/stories/2022/09/what-causes-inflation)  

### 2. Balance sheet and open market operations

Central banks also adjust the **quantity of money and liquidity** in the financial system:  
- **Asset purchases (quantitative easing)**: Buying government bonds or other securities increases bank reserves and lowers longer‑term interest rates, stimulating demand—used more when inflation is low or in recessions.[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)[9](https://en.wikipedia.org/wiki/Inflation)  
- **Asset sales or allowing assets to mature (quantitative tightening)**: Shrinking the balance sheet removes liquidity and can raise longer‑term yields, helping to cool inflation.  

These actions modify overall **money and credit conditions**, complementing short‑term interest rate changes.[9](https://en.wikipedia.org/wiki/Inflation)  

### 3. Forward guidance and communication

Because **expectations matter**, central banks use communication to **anchor inflation expectations**:  
- Public statements about future policy (“forward guidance”) signal that the central bank is committed to keeping inflation near target.  
- Clear, credible communication makes it less likely that households and firms expect runaway inflation and thus reduces self‑reinforcing price and wage increases.[1](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation)[7](https://hbr.org/2022/12/what-causes-inflation)[9](https://en.wikipedia.org/wiki/Inflation)  

### 4. Other monetary tools

Depending on the institutional framework, central banks may also use:  
- **Reserve requirements**: Changing the share of deposits banks must hold as reserves influences how much they can lend.  
- **Standing facilities**: Lending or deposit facilities at set rates help steer market interest rates and stabilize liquidity.  
- **Macroprudential policies** (often shared with regulators): Tools such as sector‑specific lending limits or capital requirements can indirectly influence credit growth and housing or asset price booms that feed into inflation.[9](https://en.wikipedia.org/wiki/Inflation)  

## Putting it together

Authoritative sources—central banks and major economic institutions—converge on a **multi‑cause view of inflation**:  
- **Short‑run**: Largely driven by demand‑pull forces, cost‑push shocks, and shifts in expectations.[1](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation)[2](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html)[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)  
- **Long‑run**: Sustained inflation is closely linked to **monetary policy**, especially prolonged periods of overly easy conditions (low interest rates and rapid money growth).[4](https://news.stanford.edu/stories/2022/09/what-causes-inflation)[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)[9](https://en.wikipedia.org/wiki/Inflation)  

Central banks try to balance these forces using their interest rate and balance‑sheet tools, while managing expectations, to keep inflation stable and predictable.  

Would you like a simple graphical framework (like a Phillips curve or AD–AS diagram) to visualize how demand, supply, and monetary policy interact to produce inflation?
