# R10 | openai/gpt-5.6-luna | run 1

## Prompt

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

## Response

Inflation is a sustained increase in the general price level, reducing the purchasing power of money. It usually results from demand growing faster than the economy’s capacity to produce goods and services, supply disruptions that raise costs, or expectations and monetary conditions that allow price increases to persist. Central banks mainly control inflation by tightening financial conditions—especially through higher interest rates—while using balance-sheet tools and communication to reinforce that stance.

## What causes inflation?

**Demand-pull inflation** occurs when household, business, or government spending outpaces the economy’s productive capacity. Strong demand allows firms to raise prices, particularly when labor, materials, or transportation are constrained. [IMF inflation overview](https://www.imf.org/-/media/Files/Publications/Fandd/Back-to-Basics/oner-inflation.ashx) ([imf.org](https://www.imf.org/-/media/Files/Publications/Fandd/Back-to-Basics/oner-inflation.ashx?utm_source=openai))

**Cost-push inflation** arises when production costs increase. Common triggers include energy and food-price shocks, supply-chain disruptions, natural disasters, labor shortages, higher wages, or currency depreciation that makes imported inputs more expensive. Supply shocks can initially raise prices even when economic growth is weak. [IMF inflation overview](https://www.imf.org/-/media/Files/Publications/Fandd/Back-to-Basics/oner-inflation.ashx) ([imf.org](https://www.imf.org/-/media/Files/Publications/Fandd/Back-to-Basics/oner-inflation.ashx?utm_source=openai))

**Inflation expectations** can make inflation self-reinforcing. If workers expect prices to rise, they may seek higher wages; if firms expect higher wages and input costs, they may raise prices in advance. If these expectations become embedded in contracts and pricing decisions, inflation can persist after the original shock fades. [IMF inflation overview](https://www.imf.org/-/media/Files/Publications/Fandd/Back-to-Basics/oner-inflation.ashx) ([imf.org](https://www.imf.org/-/media/Files/Publications/Fandd/Back-to-Basics/oner-inflation.ashx?utm_source=openai))

**Excessive monetary or fiscal stimulus** can contribute when money, credit, and aggregate spending expand faster than the economy’s ability to supply goods and services. Central banks influence these monetary conditions, while governments influence demand through taxation, spending, and borrowing.

**Imported inflation** occurs when a country’s currency weakens or global prices rise for imported commodities and goods. The effect is stronger in economies that rely heavily on imported energy, food, or manufactured inputs.

## How central banks control inflation

| Tool | How it works when fighting inflation |
|---|---|
| **Policy interest rate** | The central bank raises its short-term policy rate, increasing borrowing costs and encouraging saving. This reduces interest-sensitive consumption, housing investment, and business borrowing. |
| **Interest on bank reserves** | In systems with abundant reserves, the central bank raises the rate paid on reserve balances, helping guide short-term market rates upward. The Federal Reserve identifies this as a primary implementation tool. [Federal Reserve explanation](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm) ([federalreserve.gov](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm?utm_source=openai)) |
| **Open-market operations** | The central bank sells securities or allows them to mature without replacement, reducing liquidity and tightening financial conditions. Purchases have the opposite effect and are generally used to support demand when inflation is too low. [Federal Reserve policy tools](https://www.federalreserve.gov/monetarypolicy/policytools.htm) ([federalreserve.gov](https://www.federalreserve.gov/monetarypolicy/policytools.htm?utm_source=openai)) |
| **Quantitative tightening** | The central bank reduces its holdings of government bonds or other assets. This can put upward pressure on longer-term interest rates and withdraw monetary support. |
| **Forward guidance and communication** | Officials signal that rates will remain restrictive or that inflation will be returned to target. Credible communication can reduce inflation expectations and limit wage- and price-setting behavior. The Federal Reserve lists forward guidance among its supplementary tools. [Federal Reserve monetary policy](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm) ([federalreserve.gov](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm?utm_source=openai)) |
| **Discount-window or lending-facility rates** | Raising the rate charged on central-bank loans can discourage routine borrowing, although these facilities primarily support financial-system liquidity rather than directly suppressing inflation. [Federal Reserve policy tools](https://www.federalreserve.gov/monetarypolicy/policytools.htm) ([federalreserve.gov](https://www.federalreserve.gov/monetarypolicy/policytools.htm?utm_source=openai)) |
| **Reserve requirements** | Requiring banks to hold a larger share of deposits as reserves can restrict their capacity to extend credit. This tool is less prominent in some modern frameworks; for example, the Federal Reserve reduced U.S. reserve-requirement ratios to zero in March 2020. [Federal Reserve reserve requirements](https://www.federalreserve.gov/monetarypolicy/reservereq.htm) ([federalreserve.gov](https://www.federalreserve.gov/monetarypolicy/reservereq.htm?mod=article_inline&utm_source=openai)) |

## How monetary tightening affects the economy

Higher policy rates generally pass through to mortgages, business loans, consumer credit, bond yields, and exchange rates. Weaker borrowing and spending reduce pressure on prices; softer labor demand can also moderate wage growth. The Federal Reserve describes these channels as part of the transmission from the federal funds rate to broader financial conditions. [Federal Reserve monetary policy](https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm) ([federalreserve.gov](https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm?ftag=MSFd61514f&utm_source=openai))

Monetary policy works with delays and is more effective against demand-driven inflation than against temporary supply shocks. If inflation comes mainly from an oil shortage or disrupted supply chains, higher interest rates cannot produce more oil or restore supply; they can, however, prevent the shock from generating persistent excess demand and unanchored inflation expectations.

## Bottom line

Central banks control inflation primarily by managing **aggregate demand and inflation expectations**, not by directly setting most prices. The standard response to persistent above-target inflation is tighter monetary policy: higher interest rates, reduced balance-sheet support, and communication designed to keep expectations anchored. These measures can lower inflation but may also slow growth, weaken employment, and increase financial stress.
