# R10 | openai/gpt-5.4-mini | run 1

## Prompt

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

## Response

Inflation is usually caused by *too much demand, too little supply, or both*. Central banks control it mainly by raising or lowering short-term interest rates, which changes borrowing, spending, credit, and expectations about future inflation. 

## Main causes of inflation

- **Excess demand:** When households, firms, or governments spend faster than the economy’s capacity to produce, prices tend to rise. The IMF notes that in the long run, changes in money growth mainly affect prices, while in the short run monetary policy can affect output and inflation. 

- **Supply shocks:** Disruptions such as energy spikes, food shortages, pandemics, wars, or supply-chain bottlenecks reduce supply and push prices up. Central banks cannot fix the shock directly; they can only reduce its spillover into broader inflation. 

- **Inflation expectations:** If firms and workers expect higher inflation, they may raise prices and wages in advance, which can make inflation persistent. Central banks therefore pay close attention to expectations and communication. 

- **Money and credit conditions:** Loose monetary conditions, rapid money growth, or very easy credit can fuel spending and price pressure. The IMF and Fed both describe open market operations, reserve requirements, and interest on reserves as part of the policy toolkit that influences money and credit conditions. 

## Main tools central banks use

| Tool | What it does | Effect on inflation |
|---|---|---|
| **Policy interest rate** | Raises or lowers the cost of borrowing across the economy | Higher rates usually cool demand and reduce inflation; lower rates do the opposite  |
| **Open market operations / asset purchases** | Buys or sells securities to change liquidity and short-term rates | Tightens or eases financial conditions  |
| **Reserve requirements** | Changes how much banks must hold as reserves | Can restrict or expand lending capacity  |
| **Interest on reserves** | Pays banks interest on reserves held at the central bank | Helps steer market rates and liquidity conditions  |
| **Forward guidance / communication** | Signals the likely path of policy | Shapes expectations and can strengthen credibility  |
| **Foreign exchange intervention** | Buys or sells currency in some regimes | Can help when exchange-rate moves are feeding inflation, though scope depends on the regime  |

## How it works in practice

- When inflation is too high, central banks typically **tighten** policy by raising rates and removing liquidity. That makes credit more expensive, slows demand, and helps bring inflation back toward target. 

- When inflation is too low and demand is weak, they **ease** policy by lowering rates or buying assets. That supports spending, borrowing, and economic activity. 

- Many central banks now use **inflation targeting**, aiming to keep inflation near a publicly stated goal, commonly around 2%. 

## Bottom line

Inflation comes from demand running ahead of supply, supply shocks, and inflation expectations becoming unanchored. Central banks mainly fight it with interest-rate policy and related liquidity tools, supported by clear communication and, in some cases, asset purchases or FX operations. 

Would you like a one-paragraph version, or a U.S.-specific explanation using the Federal Reserve as the example?
