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This research explores how central banks achieve price stability and the effectiveness of different approaches.

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February 28, 2026

How Do Central Banks Control Inflation? A Guide for the Perplexed

Key Points

This research explores how central banks achieve price stability and the effectiveness of different approaches.
Described tools used by central banks, including interest on reserves and balance sheet management.
Evaluated historical effectiveness of various economic theories related to inflation control.
Presented alternative monetary approaches as complementary rather than conflicting.
Interest-rate setting is often the most effective tool for controlling inflation.
A combination of monetarist policies and fiscal support is crucial for stability.
Sometimes, pegging exchange rates or monetizing debt becomes necessary for managing inflation.

Abstract

Central banks have a primary goal of price stability. They pursue it using tools that include the interest they pay on reserves, the size and the composition of their balance sheet, and the dividends they distribute to the fiscal authority. We describe the economic theories that justify the central bank’s ability to control inflation and discuss their relative effectiveness in light of the historical record. We present alternative approaches as consistent with each other, as opposed to conflicting ideological camps. While interest-rate setting may often be superior, having both a monetarist pillar and fiscal support is essential, and at times pegging the exchange rate or monetizing the debt is inevitable. (JEL E31, E43, E52, E58, E62, F31, G21)

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How Do Central Banks Control Inflation? A Guide for the Perplexed

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