# R10 | z-ai/glm-5.2 | run 2

## Prompt

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

## Response

Inflation arises from imbalances between aggregate supply and demand, shaped by demand pressure, supply shocks, and public expectations about future prices. Central banks primarily control inflation by adjusting interest rates, but they also use balance sheet operations and other monetary tools to stabilize prices. [clevelandfed.org](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation)

## Causes of Inflation

**Demand-Pull Inflation**
When overall demand for goods and services grows faster than supply, prices rise. This can result from fiscal stimulus, monetary easing, or private spending dynamics. Demand-driven inflation is typically associated with rising output. [congress.gov](https://www.congress.gov/crs-product/R47273)

**Cost-Push Inflation**
When production costs rise notably or supply cannot meet demand, prices increase. Supply-driven inflation is associated with a decline in output relative to trend. [clevelandfed.org](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation)

**Inflation Expectations**
Public expectations about future inflation influence economic decisions, which in turn affect actual inflation. If expectations become unanchored, high inflation can become endemic. [clevelandfed.org](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation)

## Tools Central Banks Use

| Tool | Mechanism | Effect |
|------|-----------|--------|
| **Interest Rate Setting** | Central bank sets policy rate (e.g., federal funds rate) | Higher rates reduce borrowing, slowing demand; lower rates stimulate it |
| **Open Market Operations** | Buying/selling government debt to adjust money supply | Increases or decreases bank reserves and liquidity |
| **Balance Sheet Size/Composition** | Asset purchases (quantitative easing) or sales | Influences long-term rates and financial conditions |
| **Reserve Interest** | Interest paid on reserves held by banks | Sets a floor on short-term rates |

**Interest Rates as the Primary Tool**
The Federal Reserve sets the federal funds rate, which influences the prime rate and other lending rates for mortgages, credit cards, and car loans. Higher rates reduce interest-sensitive spending—business investment, consumer durables, and residential construction—thereby cooling demand. [clevelandfed.org](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation) [congress.gov](https://www.congress.gov/crs-product/R47273)

**Exchange Rate Channel**
Higher rates attract foreign capital, strengthening the domestic currency. A stronger dollar reduces import prices but makes exports more expensive, decreasing net exports. [congress.gov](https://www.congress.gov/crs-product/R47273)

**Time Lags**
Policy changes can take 18 months to several years to fully affect inflation and output, requiring forward-looking decisions. [congress.gov](https://www.congress.gov/crs-product/R47273)

## Monetary vs. Fiscal Policy

Monetary policy is the primary tool for price stability because it can be enacted quickly and precisely. Fiscal policy—reducing deficits—can also lower aggregate demand but requires large changes to significantly affect inflation and is slower to implement. [congress.gov](https://www.congress.gov/crs-product/R47273)

As Fed Chair Powell stated:

> "Central banks can and should take responsibility for delivering low and stable inflation." [congress.gov](https://www.congress.gov/crs-product/R47273)

## Long-Run Perspective

Most economists agree that long-run inflation is "always and everywhere a monetary phenomenon," ultimately determined by central bank policy. While monetary policy cannot permanently raise GDP or employment, it can permanently change the inflation rate. [congress.gov](https://www.congress.gov/crs-product/R47273)

Central banks also rely on maintaining credibility. Anchored expectations reduce the need for aggressive rate hikes, making price stability self-reinforcing. [aeaweb.org](https://www.aeaweb.org/articles?id=10.1257%2Fjel.20251429)

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How do supply chain disruptions specifically interact with monetary policy effectiveness when combating inflation?
