In a perfect economy, and all economic theroy is about perfect markets, we all want to maximise our retrn.
So when interest rates go up for a particular currency people would exchange their currency to the hight interest paying currency so they can earn higher retrn - interest.
So when rates go up, people save more - put money in fixed deposits, reduce spending - thus reduce money supply in the market. everyone wnats to convert to this high yield - one which pays more interest currency and thus it becomes more valuable.
Rupee is not exactly a fully convertible currency but people like me are to blame being a PIO i am allowed to create a FCNR acount and save money here. It pays me more to save in India, even if i do not convert it to Re. USD Interest rate in India is 5% while it is only 4.25% in US.
So there are others who sensed a boom in property market and sent money to india to buy property. hey converted USD to Re. This increated money supply as more Re were added to market. Now, Increated monet supply invariably causes inflation, which we saw over past few month and to tame this central bank can either increase CRR - cash reserve ratio - money banks need to keep with central bank - RBI as security or the overnight lending rate is increased. Which increates your interest rates. Depending on market mood this reaction can be exggerated.
