# R10 | moonshotai/kimi-k3 | run 1

## Prompt

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

## Response

Inflation arises from three broad forces — excess demand, rising production costs, and self-reinforcing expectations — while central banks control it primarily by adjusting short-term interest rates, supported by balance-sheet operations and forward guidance. Together, these tools work by restraining or stimulating overall demand so prices stabilize around an explicit target, typically 2 percent.

## What Causes Inflation

Economists group the drivers of inflation into three categories [rba.gov.au](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html) [clevelandfed.org](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation):

- **Demand-pull inflation** — Aggregate demand for goods and services grows faster than the economy's sustainable productive capacity, putting broad upward pressure on prices [rba.gov.au](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html).
- **Cost-push inflation** — The cost of producing goods and services rises sharply (e.g., energy, wages, imported inputs), or supply cannot keep pace with demand, and firms pass those costs into prices [clevelandfed.org](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation).
- **Inflation expectations** — What households and businesses expect future prices to do shapes wage demands and price-setting today, making expectations a direct driver of actual inflation [rba.gov.au](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html).

When none of these forces exert pressure, inflation tends to settle near its underlying rate, usually around 2 percent in advanced economies [clevelandfed.org](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation).

## How Central Banks Control Inflation

The Federal Reserve's statutory mandate is maximum employment, stable prices, and moderate long-term interest rates, which it operationalizes as 2 percent annual inflation in the personal consumption expenditures price index [federalreserve.gov](https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm). Its main instruments:

| Tool | Mechanism |
|---|---|
| Policy interest rate (federal funds target) | Raising the target tightens financial conditions and cools demand; lowering it eases conditions and stimulates demand [federalreserve.gov](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm) |
| Interest on reserve balances | Sets a floor under short-term rates, since banks won't lend below what they earn risk-free at the Fed [federalreserve.gov](https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm) |
| Overnight reverse repo facility | Reinforces the rate floor by offering nonbank institutions a risk-free rate [federalreserve.gov](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm) |
| Large-scale asset purchases (QE/QT) | Buying or shrinking the balance sheet influences longer-term rates and financial conditions [federalreserve.gov](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm) |
| Forward guidance | Shapes public expectations of future policy, moving financial conditions before rates change [federalreserve.gov](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm) |

**Transmission mechanism.** Changes in the policy rate ripple through other interest rates — the prime rate, mortgages, credit cards, car loans — altering household and business spending, which then affects economic activity, employment, and ultimately inflation [federalreserve.gov](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm) [clevelandfed.org](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation). Tightening is warranted when demand outstrips capacity and inflation rises; easing is appropriate when the economy is sluggish or inflation runs too low [federalreserve.gov](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm).

**The broader framework.** Recent scholarship describes price stability as resting on more than rate-setting alone: interest on reserves, balance-sheet size and composition, and transfers to the fiscal authority all play roles, with a monetarist pillar and fiscal backing proving essential complements to interest-rate policy — and exchange-rate pegs or debt monetization sometimes unavoidable in extreme circumstances [aeaweb.org](https://www.aeaweb.org/articles?id=10.1257%2Fjel.20251429).

Would you like a deeper look at how interest-rate changes transmit to consumer prices with real-world lags, or how the 2021–2023 inflation episode tested these tools?
