How does raising interest rates calm inflation? My understanding is that by raising interest rates, domestic CPI indices are less likely to rise signicantly. However, raising interest rates also attracts capital inflows and can create asset bubbles. Can these asset bubbles not influence the level of inflation? It seems that a high demand for a country’s currency might indirectly cause inflation through asset bubbles even in a floating system. (I’m thinking specifically about the Bundesbank using rates to combat inflation)

Any thoughts appreciated.
I will give you some simplified thoughts in three brief sections:



The traditional view is that higher rates increase the cost of investment and increase the opportunity cost of spending (rather than saving). This places downward pressure on prices. Another way to think about this (opportunity cost part) is considering that higher rates reduce liquidity, which in turn reduces the demand for goods and services. 



Asset prices typically move in the opposite direction of interest rates. So, raising rates to cool inflation would actually, according to the common understanding, place downward pressure on asset prices. However, if one looks into the data, one can see that there are co-movements in asset prices and rates. These co-movements are the basis of Karadi's newest paper that is currently R&amp;R'd. However, Gali does have a paper suggesting a link between rates and asset bubbles wherein increasing interest rates can impact the short-run behavior of rational bubbles. 



Higher rates can encourage capital inflows. This can cause currency appreciation. This generates its own set of issues.