# R10 | deepseek/deepseek-v4-pro | run 2

## Prompt

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

## Response

Inflation arises primarily from an imbalance between aggregate supply and aggregate demand, and central banks control it mainly by adjusting short-term interest rates to influence borrowing, spending, and investment across the economy.

## What Causes Inflation

Economists identify three broad drivers of inflation: demand-pull, cost-push, and inflation expectations. In practice, episodes of rising prices often reflect a mix of these forces.

**Demand-Pull Inflation**
When overall demand for goods and services grows faster than the economy’s ability to produce them, prices rise. This can result from fiscal stimulus, loose monetary policy, or strong private-sector spending [clevelandfed.org](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation).

**Cost-Push Inflation**
When the cost of inputs such as energy, labor, or raw materials increases sharply — or when supply chain disruptions reduce output — producers pass higher costs on to consumers. This form of inflation tends to coincide with falling output [rba.gov.au](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html).

**Inflation Expectations**
What households and businesses expect inflation to be in the future influences their behavior today — for instance, workers may demand higher wages, and firms may preemptively raise prices. These expectations can become self-fulfilling, embedding higher inflation into the economy [clevelandfed.org](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation).

**The Monetary Link**
Over the long run, most economists agree that sustained inflation is fundamentally a monetary phenomenon. As a Congressional Research Service report notes, “in the long run generally, inflation is said to be ‘always and everywhere a monetary phenomenon,’ meaning it is driven by monetary policy” [congress.gov](https://www.congress.gov/crs-product/R47273). When the supply of money and credit grows faster than the economy’s productive capacity, the result is persistent upward pressure on prices.

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## How Central Banks Control Inflation

Central banks hold a mandate for price stability and deploy several tools to manage inflation. The primary lever is the policy interest rate.

### The Federal Funds Rate (U.S. Example)
The Federal Reserve sets a target for the federal funds rate — the overnight rate banks charge each other for lending reserves. Changes in this rate ripple through the broader economy:

- **Direct transmission**: The federal funds rate influences the prime rate, which in turn affects borrowing costs for mortgages, credit cards, auto loans, and business credit [clevelandfed.org](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation).
- **Interest-sensitive spending**: Higher rates reduce demand for business capital investment, consumer durables (cars, appliances), and new housing construction. Lower rates stimulate this spending [congress.gov](https://www.congress.gov/crs-product/R47273).
- **Exchange rate channel**: Higher U.S. rates attract foreign capital, strengthening the dollar. A stronger dollar makes imports cheaper and exports more expensive, reducing net exports and further cooling aggregate demand [congress.gov](https://www.congress.gov/crs-product/R47273).

### Open Market Operations
The Fed adjusts the money supply by buying or selling government securities. Purchasing securities adds reserves to the banking system, expanding the money supply and putting downward pressure on short-term interest rates. Selling securities drains reserves, tightening monetary conditions [imf.org](https://www.imf.org/en/publications/fandd/issues/series/back-to-basics/monetary-policy).

### Additional Tools
Beyond the policy rate, central banks can use:
- **Interest on reserves**: Paying interest on bank reserves held at the central bank to influence lending behavior [aeaweb.org](https://www.aeaweb.org/articles?id=10.1257%2Fjel.20251429).
- **Balance sheet management**: Adjusting the size and composition of assets the central bank holds, such as through quantitative easing or tightening [aeaweb.org](https://www.aeaweb.org/articles?id=10.1257%2Fjel.20251429).
- **Quantitative easing/tightening**: Purchasing or selling longer-term securities to influence longer-term interest rates when the policy rate is near zero.

### Why Interest Rates Are the Preferred Tool
Reducing aggregate demand through higher interest rates is generally faster and more flexible than attempting to boost aggregate supply, which depends on structural factors like labor force growth and technological innovation. However, the tool is blunt — monetary tightening has historically raised recession risk, and its full effects can take 18 months to several years to materialize [congress.gov](https://www.congress.gov/crs-product/R47273).

Would you like a deeper explanation of how inflation expectations become self-fulfilling, or how quantitative easing differs from conventional rate policy?
