# R10 | mistralai/mistral-small-2603 | run 1

## Prompt

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

## Response

Central banks primarily combat inflation via interest-rate adjustments, balance-sheet operations, and forward guidance, while inflation itself stems from excess demand, rising production costs, or elevated expectations. The measures central banks deploy act through the Federal funds rate, interest on reserves, forward guidance, and selective asset purchases.

Inflation is driven by three core forces:

- **Demand-pull inflation**
  Occurs when aggregate demand outstrips the economy’s ability to supply goods and services sustainably. This excess demand pushes prices higher until supply catches up [rba.gov.au/education/resources/explainers/causes-of-inflation.html](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html) [clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation).

- **Cost-push inflation**
  Arises when production costs for key inputs surge or supply disruptions limit output, elevating prices even when demand has not increased [rba.gov.au/education/resources/explainers/causes-of-inflation.html](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html) [clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation).

- **Inflation expectations**
  Households and businesses base pricing decisions on perceived future inflation rates; if expectations rise, prices and wages adjust upward, validating higher inflation [rba.gov.au/education/resources/explainers/causes-of-inflation.html](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html) [clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation).

Central banks target inflation using several instruments:

| Tool | Function | How it acts |
|---|---|---|
| **Federal funds rate** | Primary lever for monetary policy [federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm](https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm) | Raising the target tightens financial conditions (higher borrowing costs, stronger currency), slowing demand; lowering the target eases conditions to stimulate demand [federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm) |
| **Interest on reserve balances (IORB)** | Sets a floor under short-term rates [federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm](https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm) | Banks rarely lend below what they earn on reserves, anchoring the overnight market near the Fed’s target range |
| **Overnight reverse repurchase (ON RRP) facility** | Supports rate control by offering an alternative risk-free investment to non-bank counterparties [federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm) | Sets a ceiling; rates above ON RRP are unattractive, helping keep market rates inside the target range |
| **Large-scale asset purchases (quantitative easing)** | Expands the central bank’s balance sheet to lower longer-term yields and ease broader financial conditions [federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm) | Used when the policy rate is near zero to add stimulus |
| **Forward guidance** | Shapes expectations by signaling the intended future path of policy [federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm) | Influences borrowing, spending, and pricing decisions today by communicating future rate settings |
| **Balance-sheet adjustment and dividend policy** | Modifies size/composition of assets and flows to the fiscal authority [aeaweb.org/articles?id=10.1257%2Fjel.20251429](https://www.aeaweb.org/articles?id=10.1257%2Fjel.20251429) | Reinforces or relaxes policy stance alongside rate changes |

What the goals of monetary policy are and how the instruments feed into the real economy:

- When inflation is too high, central banks tighten policy—raising the policy rate, shrinking the balance sheet, or steering expectations—until demand cools relative to supply, reducing price pressures [federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm](https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm) [federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm).
- When inflation is too low or growth sluggish, easing stimulus lowers borrowing costs, supports asset prices, and encourages spending to lift activity and expectations [federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm](https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm) [federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm).

Which tools central banks use depends on the inflation source and the prevailing state of the economy. Raising rates is the most common response to demand-driven inflation, whereas supply shocks may require a mix of patience and targeted measures while expectations are anchored [aeaweb.org/articles?id=10.1257%2Fjel.20251429](https://www.aeaweb.org/articles?id=10.1257%2Fjel.20251429) [rba.gov.au/education/resources/explainers/causes-of-inflation.html](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html).

Which inflation driver is most relevant to the current environment—demand, costs, or expectations—and why?
