# R10 | meta/muse-spark-1.1 | run 1

## Prompt

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

## Response

Inflation's drivers and central bank responses are well documented — I'll pull authoritative explanations and cite the key tools used to control it.

Inflation is a sustained rise in the general price level, or a fall in money's purchasing power, and central banks aim to keep it low and stable — typically around 2% — to avoid economic distortions.

### What causes inflation?

**1. Demand-pull inflation** — when aggregate demand exceeds sustainable supply. The Reserve Bank of Australia groups causes into three broad categories: demand-pull, cost-push and inflation expectations [RBA Explainer](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html), and defines demand-pull as arising when total demand for goods and services increases to exceed the supply that can be sustainably produced [RBA Explainer](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html). The U.S. Congress research summary describes this as “too much money chasing too few goods” — upward pressure on prices when demand exceeds capacity [Congressional Research Service](https://www.congress.gov/crs-product/IF10477). Causes include increased consumer, business or government spending, net exports, and rapid money supply growth.

**2. Cost-push inflation** — when aggregate supply falls because production costs rise. This occurs when the total supply of goods and services falls, often caused by an increase in the cost of production [RBA Explainer](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html). The Congressional summary notes it occurs when the prices of input goods and services increase, classic example being an oil shock [Congressional Research Service](https://www.congress.gov/crs-product/IF10477). Supply disruptions, imported input costs, and currency depreciation can feed through this channel.

**3. Inflation expectations** — beliefs about future prices become self-fulfilling. Inflation expectations are the beliefs households and firms have about future price increases [RBA Explainer](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html) and can cause higher actual inflation if firms raise prices and workers demand higher wages to offset expected loss of purchasing power. Behaviours sometimes called ‘inflation psychology’ can contribute to higher actual inflation so that expectations become self-fulfilling [RBA Explainer](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html). Congress also notes changes in inflation expectations can cause changes in actual inflation [Congressional Research Service](https://www.congress.gov/crs-product/IF10477).

### How central banks control inflation?

Central banks have a primary goal of price stability and pursue it using tools that include the interest they pay on reserves, the size and the composition of their balance sheet, and dividends [AEA Journal](http://www.aeaweb.org/articles?id=10.1257/jel.20251429).

**1. Policy interest rate.** The Fed's primary tool is the federal funds rate — the rate banks pay for overnight borrowing [Federal Reserve FAQ](http://www.federalreserve.gov/faqs/money_12856.htm). It influences employment and inflation primarily through using its policy tools to affect overall financial conditions — including availability and cost of credit [Federal Reserve FAQ](http://www.federalreserve.gov/faqs/money_12856.htm). When the central bank tightens, borrowing costs rise and consumers are less likely to buy financed items like houses or cars [IMF Explainer](http://imf.org/en/publications/fandd/issues/series/back-to-basics/monetary-policy).

**2. Open market operations and reserves.** The basic approach is to change the size of the money supply, usually done through open-market operations, in which short-term government debt is exchanged with the private sector [IMF Explainer](http://imf.org/en/publications/fandd/issues/series/back-to-basics/monetary-policy). Buying securities adds reserves and loosens policy; selling or lending securities reduces money supply and tightens.

**3. Balance sheet tools — QE/QT.** When policy rates hit zero, central banks use unconventional tools. Quantitative easing increases the size of the central bank's balance sheet and injects new cash [IMF Explainer](http://imf.org/en/publications/fandd/issues/series/back-to-basics/monetary-policy). Quantitative tightening does the reverse.

**4. Communication and expectations channel.** Central banks focus on one “policy rate”—generally a short-term, often overnight, rate [IMF Explainer](http://imf.org/en/publications/fandd/issues/series/back-to-basics/monetary-policy). By signaling future rate paths, they anchor expectations: if policymakers hike and communicate further hikes, long-term contracts build in more modest wage and price increases.

Together, these tools reduce demand when inflation is high (restrictive policy) and stimulate demand when inflation is too low (accommodative policy), keeping inflation near target.

Would you like a comparison of how the Fed, ECB, and Reserve Bank of Australia currently apply these tools?
