# R10 | openai/gpt-5.6-luna | 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 rise in the general price level, which reduces the purchasing power of money. It usually reflects demand growing faster than productive capacity, rising production costs or supply disruptions, expanding money and credit, or expectations that cause wages and prices to keep rising. Central banks mainly control inflation by tightening financial conditions—especially by raising short-term interest rates—but their tools work best against demand-driven and persistent inflation, not one-time supply shocks.

## What causes inflation?

| Cause | How it produces inflation |
|---|---|
| **Demand-pull inflation** | Households, businesses, or governments increase spending faster than the economy can produce goods and services. Firms respond to excess demand by raising prices. |
| **Cost-push inflation** | Energy, food, wages, transportation, imported inputs, or other production costs rise, causing firms to increase prices or reduce output. |
| **Monetary expansion** | If money and credit grow persistently faster than the economy’s capacity to produce goods and services, the currency’s purchasing power can decline and prices can rise. |
| **Inflation expectations** | If workers and businesses expect higher inflation, they may negotiate higher wages and set higher prices in advance. Those decisions can make expected inflation self-reinforcing. |
| **Exchange-rate depreciation** | A weaker currency raises the domestic price of imported goods, energy, and intermediate inputs, creating “imported” inflation. |
| **Supply constraints** | Natural disasters, wars, trade disruptions, labor shortages, or damaged infrastructure can reduce supply and raise prices, particularly for affected goods. |

The [International Monetary Fund’s overview of inflation](https://www.imf.org/-/media/Files/Publications/Fandd/Back-to-Basics/oner-inflation.ashx) distinguishes between monetary, demand-side, supply-side, and expectations-based causes. It also notes that the appropriate response depends on the source: higher interest rates can restrain excess demand, but they cannot directly produce more oil, food, housing, or semiconductors.

## How central banks control inflation

### 1. Raise policy interest rates

The primary tool is usually an increase in a short-term policy rate. Higher rates tend to:

- Make mortgages, business loans, credit cards, and other borrowing more expensive.
- Encourage saving rather than immediate consumption.
- Reduce interest-sensitive business investment and housing demand.
- Tighten broader financial conditions through bond, equity, and exchange-rate markets.
- Slow aggregate demand and reduce pressure on prices.

The Federal Reserve explains that raising the federal funds rate tightens financial conditions and can be appropriate when the economy is overheating or inflation is too high. See the [Federal Reserve’s monetary-policy explanation](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm).

### 2. Sell assets or reduce the balance sheet

Central banks can withdraw liquidity by selling securities or allowing previously purchased securities to mature without replacement. This is often called **quantitative tightening**. It can place upward pressure on longer-term interest rates and reduce the amount of liquidity supporting financial markets.

The reverse policy—large-scale asset purchases, or **quantitative easing**—is generally used to stimulate an economy when rates are already very low, not as the normal first response to inflation. The Fed describes both asset purchases and balance-sheet reductions in its [monetary-policy materials](https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm).

### 3. Pay interest on bank reserves

In systems with abundant reserves, a central bank can influence market interest rates by changing the interest it pays banks on balances held at the central bank. Raising that rate makes banks less willing to lend reserves at lower rates and helps transmit a tighter policy stance.

The Federal Reserve describes interest on reserve balances as a mechanism for keeping the federal funds rate within its target range in its [official policy-tools overview](https://www.federalreserve.gov/monetarypolicy/policytools.htm).

### 4. Use open-market and repo operations

Central banks buy or sell securities, or lend and absorb funds through repurchase agreements, to manage short-term liquidity and keep market rates aligned with the desired policy stance. Selling securities or conducting reverse repos generally withdraws liquidity; lending against securities adds liquidity.

The Fed lists [open-market operations, repo facilities, and related instruments](https://www.federalreserve.gov/monetarypolicy/policytools.htm) among its implementation tools.

### 5. Adjust reserve requirements

A central bank can require banks to hold a larger share of deposits as reserves, potentially limiting funds available for lending. This tool was historically important, but many central banks now rely more heavily on administered interest rates and market operations. In the United States, reserve-requirement ratios were reduced to zero effective March 26, 2020, according to the [Federal Reserve](https://www.federalreserve.gov/monetarypolicy/reservereq.htm).

### 6. Guide inflation expectations

Central banks use public statements, forecasts, policy commitments, and **forward guidance** to influence expectations about future interest rates and inflation. Credible communication can reduce the risk that workers and firms build high expected inflation into wages, rents, contracts, and prices.

The IMF emphasizes that the credibility of a central bank affects how strongly its communications influence inflation expectations; the Fed also identifies [forward guidance as a monetary-policy tool](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm).

## What central banks can—and cannot—do

- **They can:** reduce excessive demand, slow credit growth, stabilize inflation expectations, and prevent temporary price shocks from becoming persistent.
- **They cannot quickly:** increase the supply of housing, energy, food, labor, or imported goods.
- **The trade-off:** tightening policy can lower inflation but also weaken economic growth and employment, especially when inflation is largely supply-driven.
- **Policy mix matters:** fiscal restraint, improved supply capacity, energy policy, competition policy, and measures that remove bottlenecks may complement monetary policy when the main problem is on the supply side.

In short, central banks control inflation indirectly by influencing borrowing costs, spending, investment, asset prices, exchange rates, liquidity, and expectations. Their strongest leverage is over *persistent inflation caused by excess nominal demand*; supply-driven inflation usually requires additional economic and government policies.
