# R10 | perplexity/sonar-pro | run 1

## Prompt

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

## Response

Inflation is primarily driven by the interaction of **demand**, **supply**, **money**, and **expectations**, and there is no single universal cause across all episodes.[9](https://en.wikipedia.org/wiki/Inflation) Central banks mainly control inflation using **monetary policy tools**—especially short‑term interest rates, management of the money supply, and forward guidance about future policy and inflation.[4](https://news.stanford.edu/stories/2022/09/what-causes-inflation)[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)

---

## What Causes Inflation?

**1. Demand‑pull inflation (excess demand)**  
When total demand for goods and services exceeds the economy’s 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)[2](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html)  
- This occurs when **aggregate demand** (households, firms, government, and foreign buyers) grows faster than **aggregate supply**.[2](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html)  
- Examples include strong post‑recession recoveries, large fiscal stimulus, or credit booms that fuel spending.[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)

**2. Cost‑push inflation (negative supply shocks)**  
Inflation also arises when the **cost of production** rises or the supply of goods and services is constrained, 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)  
- Drivers include higher **energy prices**, more expensive raw materials, rising wages, supply‑chain disruptions, and regulatory or geopolitical shocks.[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)[6](https://www.bls.gov/opub/mlr/2023/beyond-bls/what-caused-inflation-to-spike-after-2020.htm)  
- Post‑2020 research finds that energy price volatility, supply‑chain backlogs, and auto‑sector disruptions were major contributors to the inflation spike in many economies.[6](https://www.bls.gov/opub/mlr/2023/beyond-bls/what-caused-inflation-to-spike-after-2020.htm)

**3. Inflation expectations**

Expectations about future inflation can become **self‑fulfilling**: if households and firms expect prices to rise, they adjust wages, contracts, and prices today, which can sustain or amplify 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)[9](https://en.wikipedia.org/wiki/Inflation)  
- Central banks and many modern models explicitly include expectations alongside demand and supply shocks in explaining inflation.[9](https://en.wikipedia.org/wiki/Inflation)

**4. Money supply and “easy” monetary policy**

Over longer periods, many economists highlight **monetary policy and money growth** as central drivers of sustained inflation.[4](https://news.stanford.edu/stories/2022/09/what-causes-inflation)[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)  
- Inflation tends to rise when a central bank keeps policy **interest rates too low for too long** or allows money supply to grow rapidly (“easy monetary policy”).[4](https://news.stanford.edu/stories/2022/09/what-causes-inflation)[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)  
- John Taylor and others emphasize that overly accommodative monetary policy has been a key cause of recent high inflation episodes.[4](https://news.stanford.edu/stories/2022/09/what-causes-inflation)  

**5. Multiple interacting causes**

Modern analyses stress that **several mechanisms operate at once**: firm pricing decisions, central bank policy, and fiscal dynamics (such as government debt and pandemic‑related transfers) can all reinforce one another.[8](https://www.richmondfed.org/publications/research/economic_brief/2025/eb_25-20)  
- The Richmond Fed notes that recent inflation reflects combined effects of firm pricing responses to higher costs, central bank choices on the pace of tightening, and large fiscal expansions.[8](https://www.richmondfed.org/publications/research/economic_brief/2025/eb_25-20)  
- Harvard Business Review summarizes the mainstream view as a mix of **output (real activity), money, and expectations**, with no single dominant cause across all episodes.[7](https://hbr.org/2022/12/what-causes-inflation)

---

## Main Tools Central Banks Use to Control Inflation

Central banks target inflation (often around 2%) mainly through **monetary policy**, influencing interest rates, credit conditions, and expectations.[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 **core tool** is the short‑term policy interest rate (e.g., the federal funds rate in the US):  
- When inflation is **too high**, central banks **raise policy rates**, making borrowing more expensive, slowing demand for credit, consumption, and investment, and cooling price pressures.[4](https://news.stanford.edu/stories/2022/09/what-causes-inflation)[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)  
- John Taylor argues that increasing rates “by a sufficient amount” when inflation rises is the most effective way to bring inflation back toward target.[4](https://news.stanford.edu/stories/2022/09/what-causes-inflation)  
- Conversely, lowering rates supports demand when inflation is below target, but if kept too low for too long, it can fuel future inflation.[4](https://news.stanford.edu/stories/2022/09/what-causes-inflation)

### 2. Control of Money and Liquidity

Central banks influence the **money supply** and overall liquidity in the financial system:  
- By conducting open market operations—buying or selling government securities—they adjust bank reserves and the supply of base money, affecting credit conditions.[9](https://en.wikipedia.org/wiki/Inflation)  
- Sustained rapid money growth is associated with long‑run inflation, so tightening liquidity can help restrain persistent price increases.[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)

### 3. Balance Sheet Policies (Quantitative Easing/Tightening)

Modern central banks use their **balance sheet** as a tool:  
- **Quantitative easing (QE)**: large‑scale asset purchases lower long‑term interest rates and support demand, which can raise inflation when it is too low.[9](https://en.wikipedia.org/wiki/Inflation)  
- **Quantitative tightening (QT)** or allowing assets to mature without reinvestment reduces liquidity and can help cool an overheated economy and inflation.[9](https://en.wikipedia.org/wiki/Inflation)

### 4. Forward Guidance and Communication

Because expectations matter, central banks use **communication** as a policy tool:  
- Clear statements about future interest rate paths, inflation goals, and reaction functions (“forward guidance”) shape market rates, wage and price setting, and inflation expectations.[7](https://hbr.org/2022/12/what-causes-inflation)[9](https://en.wikipedia.org/wiki/Inflation)  
- Anchored expectations make it easier to keep inflation near target even when temporary shocks hit.[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. Supporting Framework: Inflation Targeting

Many central banks operate under an explicit **inflation‑targeting framework**, committing to a medium‑term inflation rate (often around 2%):  
- This framework guides how aggressively they adjust interest rates and other tools in response to deviations of inflation from the target.[9](https://en.wikipedia.org/wiki/Inflation)  
- Credible targets help anchor expectations, reducing the risk that short‑term shocks lead to self‑sustaining inflation.[1](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation)

---

## How the Pieces Fit Together

Putting these elements together:  
- **Short‑run inflation** often reflects demand‑pull and cost‑push forces plus 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)  
- **Persistent inflation** typically requires supportive **monetary and fiscal conditions**, including easy monetary policy and, in recent episodes, large fiscal deficits and debt.[4](https://news.stanford.edu/stories/2022/09/what-causes-inflation)[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)[8](https://www.richmondfed.org/publications/research/economic_brief/2025/eb_25-20)  
- Central banks respond primarily by **raising interest rates**, tightening liquidity, and reinforcing their commitment to the inflation target through communication, aiming to slow demand and re‑anchor expectations.[4](https://news.stanford.edu/stories/2022/09/what-causes-inflation)[5](https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation)

Would you like a brief explanation of how these mechanisms showed up in the specific post‑2020 inflation episode in the US and Europe?
