How do central banks typically respond when inflation is high?

When inflation is high, central banks typically respond by increasing interest rates. This response is grounded in the fundamental goal of many central banks to maintain price stability and control inflation. Raising interest rates has a direct effect on borrowing costs; as the cost of borrowing increases, consumer spending and business investments tend to decrease. This reduction in spending can help alleviate upward pressure on prices, thus slowing inflation down.

Higher interest rates also encourage saving rather than spending since individuals may seek to benefit from the increased returns on savings accounts and other fixed-income investments. This shift can further dampen inflationary pressures as demand for goods and services declines.

In contrast, lowering interest rates or increasing government spending could further stimulate the economy and, in turn, exacerbate inflation. High inflation signals that economic demand is outpacing supply, so actions that promote additional spending would not be conducive to controlling inflation. Raising tax levels, while it might help to manage fiscal policy, is not a direct tool that central banks utilize to address inflation in the same manner as interest rate adjustments. Thus, increasing interest rates is the standard approach for central banks when faced with high inflation.