How can a central bank effectively control inflation?

A central bank can effectively control inflation primarily through the use of monetary policy tools, particularly by adjusting interest rates. This approach is based on the relationship between interest rates, borrowing, and spending within an economy.

When a central bank raises interest rates, borrowing costs increase. As loans become more expensive, both consumers and businesses are less likely to take on additional debt. This tends to reduce consumer spending and business investment, leading to a decrease in overall demand in the economy. With reduced demand, upward pressure on prices diminishes, which helps keep inflation in check.

Conversely, if inflation is low and the economy is sluggish, a central bank might lower interest rates to encourage borrowing and spending, thereby stimulating economic activity. This flexibility in adjusting rates is a key tool for managing inflation levels.

In contrast, other options, like increasing taxes on businesses, issuing more currency for public spending, or regulating trade policies, do not directly influence the monetary supply or credit conditions in the same way. These methods can have indirect effects on inflation, but they are not as immediate or effective as modifying interest rates through monetary policy. Thus, adjusting interest rates stands out as the most direct and powerful method for a central bank to control inflation.