What causes inflation, and how do central banks try to control it?

Inflation is the rate at which the general level of prices for goods and services rises, meaning each unit of currency buys fewer goods than before. It is generally caused by three primary factors:

• Demand-Pull Inflation: This occurs when the demand for goods and services exceeds the economy’s ability to produce them. Put simply, it is "too much money chasing too few goods."
• Cost-Push Inflation: This happens when the costs of production—such as raw materials or wages—increase. Producers pass these higher costs on to consumers in the form of higher prices.
• Built-in Inflation: Often linked to expectations, this occurs when workers demand higher wages to keep up with rising living costs, and businesses raise prices to maintain their profit margins, creating a "wage-price spiral."

How Central Banks Control Inflation

Central banks (such as the Federal Reserve in the U.S. or the European Central Bank) manage inflation primarily through monetary policy. Their main tool is adjusting interest rates:

1. Raising Interest Rates: When inflation is too high, central banks raise interest rates. This makes borrowing money more expensive for both businesses and consumers. As a result, spending and investment slow down, which cools off demand and helps stabilize prices.
2. Lowering Interest Rates: If the economy is sluggish or deflation threatens, they lower rates to encourage borrowing and spending, which stimulates economic activity.
3. Open Market Operations: Central banks can also buy or sell government securities. Selling securities reduces the amount of money circulating in the banking system, which can help tighten credit and curb inflation.
4. Reserve Requirements: By changing the amount of cash commercial banks are required to hold in reserve, central banks can influence how much money those banks have available to lend to the public.

By balancing these tools, central banks aim to keep inflation at a stable, predictable level—usually around 2% annually in many developed economies—to support long-term economic growth.