Higher interest rates also attract more capital flows, thus again, in a curious variant of the Dutch disease, accentuating the very problem that we were, in the first place, trying to resolve. As you see, there are no straight-forward solutions – every solution raises a fresh problem. Volatile capital outflows pose similarly complex policy choices.
In this case, the exchange rate tends to depreciate, again out of line with fundamentals exacerbating inflationary pressures and also hurting the government and corporates who have external debt obligations. In an outflow situation, financing of the current account deficit could also turn into a problem.