* Rate hike aimed at reversing dash for dollars, gold
* Iran's rial plummeted in value over sanctions fears
* Ahmadinejad policy U-turn ahead of parliamentary elections
* Central bank to restrict foreign currency sales
By Mitra Amiri and Robin Pomeroy
TEHRAN, Jan 25 (Reuters) - Iran increased bank interest rates on Wednesday and indicated it would further restrict sales of foreign currency, hoping to halt a spiralling currency crisis after new Western sanctions accelerated a dash for dollars by Iranians worried about their economic future.
"The economy minister has announced that (Iranian President Mahmoud) Ahmadinejad has agreed with the approval of the Money and Credit Council to increase interest rates on bank deposits to up to 21 percent," the official IRNA news agency reported.
The central bank also told Iranians they should only buy dollars if they are travelling and not hoard them to guard against economic uncertainty.
New U.S. and European sanctions targeting Iran's vital oil exports and its central bank seriously exacerbated a slide in the Iranian currency that was already under way, creating what one senior politician described as economic instability not even witnessed during Iran's 8-year war with Iraq in the 1980s.
The West hopes the economic pressure will force Iran to curb the nuclear work they fear is aimed at making bombs but which Tehran says is entirely peaceful.
The rial started weakening after a decision last April to cut interest paid on bank deposits to a range of a 12.5-15.5 percent, below inflation which is currently around 20 percent, prompting many Iranians to withdraw savings and buy gold and foreign currency and pushing up the price of both.
The dash for those safe havens accelerated sharply after the new sanctions were announced, resulting in the rial losing 50 percent of its value against the price of dollars available on the open market in just one month.
Monday's decision marks a policy U-turn for Ahmadinejad, who faces a political test in March 2 parliamentary election. He previously vetoed efforts by Central Bank Governor Mahmoud Bahmani to increase rates.
Bahmani indicated the rate increase would be accompanied by further restrictions on the sale of foreign currency.
"We will provide foreign currency in any amount for people demanding it for various uses," he said in an interview published on the website of state broadcaster IRIB.
"Travellers, university students and patients will be supplied at an appropriate rate," he said. Importers of vital goods would also be able to buy as much foreign currency as they need.
"The government will not give foreign currency for storage," he added, implying that Iranians will no longer be allowed to exchange their rials for hard currency unless they can prove an immediate need.
The rial's slide is a huge risk to already rising inflation as Iran is heavily reliant on imported consumer and intermediate goods whose prices have surged as the rial has depreciated.
"Even during the war we did not witness such instability," Alaeddin Boroujerdi, head of parliament's foreign affairs committee, told the semi-official Fars news agency.
"Government officials and the president himself should definitely be held accountable to people and public opinion."
Ahmadinejad's representative in parliament - which is already highly critical of the president and may become more so after March 2 - said the new policy would burst what he called the bubble of gold and dollar prices.
"The effects of the new decision will be clear in the market very soon and the bubbles being created for foreign currency and gold will be removed," the ISNA news agency quoted Mohammad Reza Mirtajedini as saying.
The deputy head of parliament's economics committee criticised the government for reacting late to the crisis which he said had "no reasonable, logical basis".
"Increasing the bank deposit interest rates is an appropriate tool for people's investments but doing it in a hasty manner and the current inflamed situation of the market will not solve any problem," Mostafa Motavarzadeh told the semi-official Fars news agency.
The price of 8.133-gram gold coins dropped on the news, local media reported, to 8,500,000 rials, reversing most of last week's 45 percent increase when the price rose to 10,100,000.
The effect on the price of dollars was negligible however with ISNA saying the price had fallen on the news to 22,500 rials from 23,000 rials - still double the central bank's official "reference rate" of 11,293 rials.
However, exchange agencies contacted by Reuters said they had no dollars to sell, reflecting either a shortage of notes or a reluctance to sell in such a volatile atmosphere.