Central banks use interest rates as a key tool to control inflation by influencing the cost of borrowing and the level of economic activity. When a central bank raises interest rates, borrowing becomes more expensive, which tends to reduce consumer spending and business investment. This decrease in demand can help slow down the economy and bring down inflation. Conversely, lowering interest rates makes borrowing cheaper, stimulating spending and investment, which can boost economic activity and help prevent deflation.

The primary mechanism through which interest rates affect inflation is the control of money supply and demand. Higher interest rates typically lead to reduced borrowing and spending, lowering the overall demand for goods and services. This reduced demand can help temper price increases, thereby controlling inflation. Additionally, higher interest rates can attract foreign investment, leading to an appreciation of the national currency, which can reduce the cost of imports and further help control inflation.

However, there are potential risks associated with using interest rates as a monetary policy tool:

1. Economic Slowdown: Raising interest rates too much or too quickly can lead to a significant reduction in economic activity, potentially causing a recession. Businesses may cut back on investment and hiring, and consumers may reduce spending, leading to higher unemployment and lower economic growth.
2. Debt Burden: Higher interest rates increase the cost of servicing existing debt for both individuals and businesses. This can lead to higher default rates and financial distress, particularly if a large portion of the economy is highly leveraged.
3. Impact on Asset Prices: Higher interest rates can lead to declines in asset prices, such as stocks and real estate, as the cost of financing increases and future cash flows are discounted at a higher rate. This can reduce household wealth and dampen consumer confidence and spending.
4. Currency Appreciation: While a stronger currency can help control inflation by making imports cheaper, it can also hurt export competitiveness. A higher exchange rate can make a country’s goods and services more expensive for foreign buyers, potentially leading to a trade deficit and slower economic growth.
5. Time Lags: The effects of interest rate changes on the economy and inflation are not immediate. There can be significant time lags before the full impact is felt, making it challenging for central banks to time their interventions correctly. This can lead to either an over- or under-shooting of their inflation targets.
6. Global Spillovers: In a globally interconnected economy, changes in interest rates can have spillover effects on other countries. For instance, higher interest rates in a major economy can attract capital flows from emerging markets, leading to financial instability and currency depreciation in those markets.

Central banks must carefully balance these risks when using interest rates to control inflation, often relying on a range of economic indicators and models to guide their decisions. They also communicate their policy intentions to manage market expectations and minimize potential adverse effects.