Monetary and Macro Theory
Okey yesterday already discussed about
Until the middle of the twentieth century, most economists found no
fault with the fact that the present banking and financial system is
interestbased. In the mid sixties of the last century, some economists noticed
that the current macroeconomic theory is devoid of any satisfactory and
acceptable rationale for holding money. As a result of this realization,
attempts were made to introduce money explicitly into theory, while building
the micro foundations of macroeconomics. During such process, it was natural to
look into the issue of optimal monetary policies.
Only then, they stumbled on
the Friedman's monetary rule that a zero nominal interest rate is a necessary
and sufficient condition for optimal allocative efficiency. In a fiat-money
world, adding one marginal unit of real balances costs no real resources to the
community. Imposing a positive price on the use of money would lead traders to
economize on its use, by using real resources. However, when the rate of
interest is zero, traders will have no incentive to substitute real resources
for money. More real resources can therefore be directed to consumption and investment. These results
imply that the long forgotten Christian and Jewish teachings as well as those
of Islam and Hinduism that prohibit the charge of interest on loans are not an
aberration. I
n a conventional market economy the rate of interest can be
brought down to zero only through deflating the economy at a rate equal to the real
rate of interest, which can be attained by steadily contracting the money
supply at a rate equal to the representative household time preference. Such
policy rule clearly implies that central bankers should implement a long-run
policy of deflation, something that they would never accept. With deflating the
economy, some economists would worry about the existence of a liquidity trap
when the rate of interest is zero. Other economists advise to exercise
deflationary policies only asymptotically in order to apply the Friedman's
Rule. Others point out that monetary authorities would have less leeway with
adjusting the interest rate downwards in the face of recession if the rate of
interest is very low. Certainly, deflation has efficiency problems parallel to
those of inflation, even at very low interest rates. While many economists
believe that problems involved with zero interest rates are all surmountable,
monetary authorities are not yet impressed.
The fact that Islamic banking and
finance avoids the use of interest-based lending has significant implications
to monetary policy. In managing the money supply, the monetary authority would
monitor the real rate of growth and set the rate of monetary expansion to the
level consistent with price stability and expected real growth. Some Islamic
economists propose a 100 per cent required reserve ratio in order to give the
authorities absolute control of the money supply and to appropriate all
seigniorage resulting from monetary expansion to the government instead of
banks' shareholders. The fact that the economy is as close as possible to price
stability implies that the rate of monetary growth is optimal, and there is no
need to divert real resources to monetary use. Therefore, Pareto optimality is
assured without problematic deflationary policies. Meanwhile, people can use
their cash balances to carry out spot purchases. Those with insufficient cash
balances for their current purchases of assets and/or commodities can revert to
finance. The rate of interest is replaced by the rate of profit on equity and
profit-sharing finance, by markups on credit-purchase finance and by rental
rates on leasing finance. While the time-value of money is maintained, there is
no need to handle the complicated questions of how to bring the rate of
interest down to zero in order to reach the optimal allocation of resources.
In
case of profit sharing modes of Islamic finance, focus would be on the
profitability and rate of return of the concerned investment. Financial
resources would be directed to the most productive investments. This would
increase the efficiency of the financing process and also reinforce efficiency
in the real sectors. In credit-purchase and leasing modes of Islamic finance,
money is not given outright, but rather commodities are given in return for
debt obligations.
Credit expansion in the face of increasing credit-purchase of
assets and commodities would be tied directly to higher demand for assets and
commodities, which would have a direct bearing on aggregate supply.
Consequently, credit finance under Islamic finance would be less inflationary
in comparison to conventional banking and finance.
