# R10 | meta/muse-spark-1.1 | run 2

## Prompt

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

## Response

I'll pull together authoritative explanations of what drives inflation and the tools central banks use to control it.

Inflation is a sustained increase in the general price level, typically measured by the Consumer Price Index (CPI) or PCE Price Index. It occurs when spending outpaces productive capacity, when production costs rise, or when expectations of future price increases become self-fulfilling.

## What Causes Inflation

Economists group the causes into three broad categories [Reserve Bank of Australia](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html):

**1. Demand-pull inflation**
Arises when total demand for goods and services (aggregate demand) increases to exceed the supply that can be sustainably produced [Reserve Bank of Australia](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html). When aggregate demand exceeds potential output, it puts upward pressure on prices [Reserve Bank of Australia](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html). Causes include increased consumer, business or government spending or stronger net exports.

**2. Cost-push inflation**
Occurs when aggregate supply falls, often caused by an increase in the cost of production [Reserve Bank of Australia](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html). If aggregate supply falls but demand remains unchanged, inflation is 'pushed' higher [Reserve Bank of Australia](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html). Examples:

* Higher imported or domestic input costs like oil or raw materials
* Supply disruptions from weather, natural disasters, or geopolitics
* Currency depreciation, which raises the price of imported goods and contributes directly to inflation through the cost-push channel [Reserve Bank of Australia](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html)

Over the long term, monetary factors also matter: rapid growth in the money supply when the economy is at full employment fuels inflation.

**3. Inflation expectations / Built-in inflation**
Inflation expectations are the beliefs households and firms have about future price increases [Reserve Bank of Australia](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html). If firms expect higher future inflation, they may raise prices faster, and workers may demand higher wages to make up for expected loss of purchasing power [Reserve Bank of Australia](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html). These behaviours can make expectations self-fulfilling [Reserve Bank of Australia](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html).

When expectations are anchored to the central bank's target, temporary price shocks fade. When unanchored, they can create persistent inflation and stagflation.

## What Tools Do Central Banks Use to Control It

Central banks have a primary goal of price stability. The ECB states its mission is to make sure inflation remains at 2% over the medium term, using tools to influence what it costs to borrow money [ECB Toolkit](https://www.ecb.europa.eu/mopo/strategy/strategy-review/strategy-review-assessment-2025/html/monetary-policy-toolkit.en.html).

**1. Policy interest rate - Primary tool**
The Federal Reserve's primary tool is the federal funds rate — the rate banks pay for overnight borrowing [Federal Reserve FAQ](https://www.federalreserve.gov/faqs/money_12856.htm). The Fed changes the stance of monetary policy primarily by raising or lowering its target range for the federal funds rate [Fed Explained](https://federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm).

* Raising the target represents tightening, which raises interest rates and may be necessary if the economy is overheating or inflation is too high [Fed Explained](https://federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm).
* Lowering the target represents easing when the economy is sluggish or inflation is too low [Fed Explained](https://federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm).

Changes influence other interest rates, borrowing costs for households and businesses, broader financial conditions, demand, and ultimately inflation [Federal Reserve FAQ](https://www.federalreserve.gov/faqs/money_12856.htm). Other central banks use the same mechanism.

**2. Implementation tools**
To keep market rates near target, the Fed uses:

* Interest on reserve balances
* Overnight reverse repurchase facility rate [Fed Explained](https://federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm)

Its main toolkit also includes key policy rates beyond this, plus additional tools that reinforce the stance or ensure transmission across markets [ECB Toolkit](https://www.ecb.europa.eu/mopo/strategy/strategy-review/strategy-review-assessment-2025/html/monetary-policy-toolkit.en.html).

**3. Balance sheet and unconventional tools**
* Large-scale asset purchases (quantitative easing) / asset sales (quantitative tightening) to affect longer-term rates and financial conditions
* Forward guidance — setting the public's expectations for future policy actions [Fed Explained](https://federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm)
* Reserve requirements and open market operations buying/selling government securities to affect money supply

The transmission is indirect: monetary policy affects overall financial conditions — including the availability and cost of credit — which then influences spending, employment, and inflation [Federal Reserve FAQ](https://www.federalreserve.gov/faqs/money_12856.htm).

Would you like a breakdown of how these tools have been used in the current 2023-2026 inflation cycle in the US and Eurozone?
