# R10 | deepseek/deepseek-v4-pro | run 1

## Prompt

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

## Response

Inflation is driven primarily by three forces: demand outpacing supply, rising production costs, and expectations about future price increases. Central banks combat inflation mainly by raising interest rates — specifically their target for the overnight lending rate — which cools aggregate demand, and they supplement this with balance sheet tools and forward guidance.

## What Causes Inflation?

The main causes of inflation fall into three categories, which often interact.

### Demand-Pull Inflation
This occurs when total demand for goods and services exceeds the economy’s ability to produce them. Excess demand bids up prices across a broad range of sectors. [rba.gov.au](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html). The Federal Reserve Bank of Cleveland describes it as “growing demand outstrips changes in the supply of goods and services.” [clevelandfed.org](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation)

### Cost-Push Inflation
Cost-push inflation arises when the cost of producing goods and services rises notably — for example, through higher energy prices, raw material costs, or wages — or when supply is constrained. Producers pass these higher input costs on to consumers. [clevelandfed.org](https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/what-causes-inflation) The Reserve Bank of Australia explains this as “the effect of higher input costs on the supply side of the economy.” [rba.gov.au](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html)

### Inflation Expectations
What households and businesses believe will happen to future prices directly shapes actual inflation. If people expect higher inflation, they may demand higher wages and accept higher prices, creating a self-fulfilling cycle. [rba.gov.au](https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html) The Cleveland Fed notes that these expectations “influence economic decisions, and this, in turn, affects inflation.” [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

Central banks primarily pursue price stability — the Federal Reserve aims for 2 percent annual inflation as measured by the Personal Consumption Expenditures price index, alongside maximum employment. [federalreserve.gov](https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm) They deploy several tools to achieve this.

### Primary Tool: Policy Interest Rates
The dominant instrument is the central bank’s short-term policy rate. The Federal Reserve’s Federal Open Market Committee (FOMC) sets a target range for the **federal funds rate** — the interest rate at which banks lend reserves to each other overnight. [federalreserve.gov](https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm)

- **To fight high inflation (tightening):** The central bank raises its target rate. This increases borrowing costs throughout the economy — for mortgages, credit cards, and business loans — which reduces overall demand, slows economic activity, and brings inflation down. [federalreserve.gov](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm)
- **To stimulate a sluggish economy (easing):** The central bank lowers its target rate, making credit cheaper, spurring demand, and pushing inflation toward its target. [federalreserve.gov](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm)

The Fed implements this by adjusting the **interest rate on reserve balances** that banks hold at the Fed and the **overnight reverse repurchase facility rate**, which together steer market rates into the target range. [federalreserve.gov](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm)

### Supplementary Tools
Beyond rate changes, central banks use additional instruments:

- **Large-scale asset purchases (quantitative easing):** The central bank buys government bonds and other securities to inject liquidity into the financial system and lower longer-term interest rates when the policy rate is already near zero. [federalreserve.gov](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm)
- **Forward guidance:** Public communication about the likely future path of policy rates shapes expectations and influences financial conditions today. [federalreserve.gov](https://www.federalreserve.gov/aboutthefed/fedexplained/monetary-policy.htm)
- **Balance sheet composition and size:** Managing the assets the central bank holds and the dividends it distributes to the fiscal authority can also affect monetary conditions. [aeaweb.org](https://www.aeaweb.org/articles?id=10.1257%2Fjel.20251429)

A 2026 survey of the economic literature by Castillo-Martinez and Reis emphasizes that while interest-rate setting is often the superior approach, effective inflation control also depends on a credible monetary pillar and fiscal support. In some circumstances, pegging the exchange rate or monetizing government debt becomes inevitable. [aeaweb.org](https://www.aeaweb.org/articles?id=10.1257%2Fjel.20251429)

### Transmission Mechanism
Regardless of the tool, the fundamental mechanism is the same: tightening reduces aggregate demand relative to supply, which raises unemployment modestly and lowers inflation; easing stimulates demand and helps bring inflation back up when it is too low. [federalreserve.gov](https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm)

How do inflation expectations specifically complicate a central bank’s ability to bring inflation down once it has become entrenched?
