Finance Assignment Example | Topics and Well Written Essays - 1500 words

Finance - Assignment Example This affects the interest rates. An interest rate is at the very basic the cost money. It’s how much you pay to receive money and how much you earn to sell money. Banks basically help determine the interest rate. While each bank may offer different interest rates to customers, the basic rate or the discount rate is determined by the Central Bank (Mathieu, 1995, p. 64). This is the rate at which the central bank lends to all other banks. And the central bank sets this rate by considering factors such as the demand and supply of money, interest rates, exchange rates, balance of payments and the growth rate. The financial sectors set the interest rate which affects the exchange rate of a currency. A high interest rate means that the currency essentially â€Å"costs† more. It also means that if foreign investors put their money in local accounts they will get higher returns. This is known as hot money inflow. As more investors buy the local currency, the currency appreciates. While high interest rates lead to hot money inflows it also means that the country’s exports are now more expensive for foreigners. This means that if previously an American had to pay $1 for PKR 80, now they might have to pay $80/70 since $1 is now equal to PKR 70 and not PKR 80. This means that if previously an item in Pakistan cost PKR 800, the American had to pay $800/80=$10. But now since PKR has appreciated he has to pay $800/70=$11.43. So it costs him more now and depending on the elasticity of demand, he might buy less or not buy at all. So an appreciation of currency is not necessarily a good thing. On the other hand imports become cheaper. E.g. if a barrel of oil cost $100, a Pakistani importer had to pay PKR 100x80=PKR 8000 per barrel. But now he has to pay PKR 100x70= PKR 7000 per barrel. However as imports increase this can create inflationary pressures in the economy and on the balance of payments. If exports are greater than imports, all things held