Naturally, inflation tends to be lower when the economy contracts. Perfect macroeconomic stability is achieved only in a graveyard. Coupled with free capital flows, NB s recipe is downright dangerous. The sequence is simple and inevitable, but, luckily, fully reversible. This is a counter-cyclical Keynesian reflex.
Money is injected into a languishing economy through the budget.
The central bank tries to counterbalance the deficit poison by applying an antidote of high interest rates. Money supply is reduced sharply. High interest rates attract speculative hot money. Where free capital flows are permitted, foreign speculative funds will drive down the exchange rates of the domestic currency versus foreign currencies. Where capital flows are more restricted, domestic corporations will borrow in foreign exchange and invest in high yielding domestic currency deposits and bonds.