Raising interest rates to prevent inflation I am reading a book about the Mundell-Fleming Model and I have encountered a part which says:


  The Fed raised U.S. interest rates several times during 1994 to prevent U.S. inflation.


Isn't it the other way round? I thought that rising interest rates causes the investment to decrease and so the money demand to decrease. When money demand decreases, price level increases. Am I wrong?
The increase in interest rates make borrowing more expensive and therefore businesses and people will borrow less. Therefore, investment and consumption decrease. Through the multiplier effects, this will cause a reduction in real GDP. This will also increase the unemployment rate. Therefore, people who sell these goods and services will reduce their prices. As a result, the overall price level will fall and the inflation rate is reduced. I understand that explanation where the money demand decreases cause a probable eventual reduction in the interest rates. However, this assume that the money supply is fixed. Now, you must understand how the Fed controls the interest rates. It controls the interest rates by controlling the money supply. It reduces the money supply by selling bonds into the economy. Therefore, the money supply shift to the left and initially, the interest rates soar. The demand and supply analysis:


First we must define some basics: We are going to use the supply and demand graph with the interest rates as the y axis and the money in x axis. Now since we know that there is a fixed amount of money in the economy and the Fed is controlling it, we know that the supply of money is strictly vertical and the demand for money is downward-sloping (with a certain elasticity)
The mechanism of the money diagram: In a fixed money supply, if there is an increase in demand of money, the demand curve will shift to the right. Now if there is a a positive inflation rate, there is an increase in demand of money with every inflation rate and therefore the demand curve will shift to the right.
The fed aims to  reduce inflation by increasing interest rates. They do this by reducing the amount of money in the economy and thus shifting the supply curve of money to the left. You are right when the total quantity of money in the equilibrium point will be reduced. However, I think that you are confused why the interest rates will not go down. This is because the Fed aims to reduce positive interest rates and not cause a negative inflation rate. In argument (2) I have explained that with a positive inflation rate, the money demand curve will always be shifting to the right. Therefore, the Fed only wants to reduce the speed of that shift.


Now you wonder why the Fed wants to reduce the inflation rate. This is because it is always desirable to have a steady price level. A high inflation rate causes some cost to the economy that it does not want. You need to google or search in the wikipedia for the negative effects of high inflation rates.