How do Interest Rates work?

I tried a number of searches and couldn’t really find the answer I’m looking for. I’m trying to understand why a bank would raise it’s interest rates. From what I understand, when a currency is over inflated, the bank (BoE, BoC or whatever) will curb the inflation by increasing their interest rates, correct?

Now what does this actually do? Investors now get more return if they invest in the currency, so foreign monies “purchase” the inflated currency. This basically decreases the inflation by “backing” the currency with foreign money?

Am I on the right track? I apologize if that’s confusing, just trying to wrap my head around fundamentals.


A country�s central bank tries to keep the economy running smoothly. A central bank looks at economic data such as factory orders, housing, consumer credit, retail sales, manufacturing orders, construction activity, and
employment figures in an effort to keep the economy from dying and growing too fast.

Instead of taking deposits and making loans like normal banks, a central bank controls the economy by increasing or decreasing the country�s money supply. Every economy in the world is based on the use of money. Therefore,
each country�s money supply determines how quickly the economy can grow.

If the central bank increases the money supply, consumers and businesses have more money to spend on goods and services, which stimulates
economic activity. When businesses and individuals have less money at their disposal, economic activity slows down.

Central banks often limit money supply growth in order to slow down the economy and control inflation.Cranking up the printing presses is not the main way a central bank increases the country�s money supply though.

In the United States, the Fed usually prints only enough bills to replace worn-out money in circulation. So how then does a central bank control its country�s money supply?

There are several ways but the method that is most relevant to the foreign exchange market is by raising or lowering interest rates. When a central bank decides an economy is growing too slowly, it reduces the interest rate
it charges on its loans to banks, which results in cheaper loans to businesses and consumers. If an economy is growing too quickly, a central bank can increase the interest rates on its loans to banks, reducing the available
supply of money and putting the brakes on economic growth.

If the central bank allows the economy to expand too rapidly by keeping too much money in circulation, it may cause unwanted inflation. If it slows down the economy by removing too much money from circulation, it may
cause an economic recession, resulting in unemployment and reduced production.

This is something I have pondered over too - and I think Ninja has explained it very well - well as far as i understand it anyway ;).

However I do have a follow on question - why when interest rates rise - does this cause an upward movement with a currency? And is it always an upward movement - for example I have seen with the NZD that when ever the RBNZ does rate hikes the currency becomes stronger - but asking for a tip here - do we expect the same to happen when the BoE makes its statement on Friday?

Investors always put their money where the best returns are, also called yield.

If a country provides a high yield, generally that’s where investors will plop down their money (assuming the country is politically and economically stable).

So when a country’s central bank raises rates, traders expect money to flow into that country and purchase investments whether it be stocks, bonds, real estate, etc. In order to for that to happen, you have to convert your native currency (sell) into the foreign currency (buy). This expectation of investors buying up currency (therefore increasing demand) is what causes the actual currency to rise after an interest rate announcement.

Here is an educational video of the US Banking and Federal Reserve system. The video also provides some historical context. Enjoy…it is about 45 minutes Money, Banking and the Federal Reserve - Google Video