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Commentary on Monetary Policy in an Islamic Economy

Dr. Chapra’s excellent paper entitled “Monetary Policy in an Islamic Economy” represents a valuable contribution to the growing Islamic economics literature. The significance of this paper lies in that it attempts not only, to design a monetary policy that is truly Islamic in character but also to assign to it a role that is quite novel and unique. To appreciate the paper and to do justice to it, one must also read Dr. Chapra’s earlier seminal work on “Money and Banking in an Islamic Framework” which was presented to the Seminar on “Monetary and Fiscal Economics of Islam” in Mecca in October 1978. However, my comments here will be confined to policy matters discussed in his present paper.

The ingenuity of the author is clearly manifested in the manner in which he has approached the whole subject, by injecting an Islamic flavour into the objectives which he sets out to achieve with the help of ‘unconventional’ monetary instruments in an interestless environment.

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I am as strongly convinced, as the author himself indeed is, that all these socio-economic goals can be achieved efficiently and effectively in an interest-free system. However, I am inclined to think that the author has quite unnecessarily overburdened the monetary policy by assigning to it too many objectives. I do not suggest that monetary policy instruments are not capable of achieving a number of objectives simultaneously in certain circumstances either independently or with the assistance of other policy tools. Nor do I suggest that all these objectives are unnecessary or unimportant. As a Muslim economist, 1 whole-heartedly subscribe to each and every objective that Dr. Chapra has listed out. But, I do question the wisdom and the practicality of expecting the monetary policy to achieve all of these objectives at the same time. It is only in this sense as I feel that Dr. Chapra has been rather unfair or unkind to the monetary policy in an Islamic framework.

It is of relevance to note that according to the famous Meade-Tin- bergen principle, the number of policy instruments should equal the number of policy objectives, if multiple objectives are to be simultaneously achieved. Otherwise, there may be conflicts of policy goals. In this regard, it is also pertinent to bear in mind the Mundellian principle of “effective market classification” which stresses the importance of appropriate pairing of policy objectives with policy instruments. It is, therefore, imperative that we assign to monetary policy what it can best achieve and leave the rest for other policy instruments. Thus, too much concern for redistributive justice in formulating and implementing the monetary policy may impose constraints which may adversely affect its overall efficiency and effectiveness. I am not at all implying that this concern for redistributive justice is wrong or misplaced. Rather, the point I wish to drive home is that it may be best achieved by activating other policy tools.

Having made my preliminary remarks on the scheme outlined by Dr. Chapra, let me come to the monetary policy itself. My general impression is that the monetary policy in Dr. Chapra’s model plays a somewhat passive role, especially with regards to the regulating of money supply, i.e. the role of avoiding liquidity shortage and liquidity glut so as to ensure stability in the value of money. Dr. Chapra’s prescription that the central bank adjusts the money stock in such a way as to keep pace with the secular growth of output implies a passive role, not one of actively influencing the level of national output and employment. Perhaps Dr. Chapra has been strongly influenced by Friedman in this regard.

Dr. Chapra also seems to believe that the control of money supply can be accomplished by merely regulating the high-powered money (Mq) at the source. He recommends a statutory reserve requirement against demand deposits only. But MQ in a modern economy accounts for only a small proportion of the total money supply, and as such the central bank’s control of MQ alone may not be sufficient. It is, therefore, necessary for the central bank to exercise similar controls on the deposit money component of the aggregate money supply as well.

The author has suggested two alternatives both of which have been motivated by his genuine concern for Islamic redistributive justice. The first alternative is to impose a 100 per cent reserve requirement on the commercial banks. This really means that the commercial banks will be reduced to safe-keeping institutions. For, then, the commercial banks cannot even invest the funds deposited with them, let alone ‘create’ deposits. This alternative, however, permits the central bank to create “credit” which will be channelled through the commercial banks on a mudarabah basis.

The second alternative is to allow the commercial banks to ‘create’ deposits. The redistributive justice will be taken care of either by nationalising the commercial banks or by forcing the banks to pass on to the state the net income arising from ‘derivative’ deposits after allowing for the mudarabah share of the commercial banks. It is not clear to me how this ‘net’ income is to be divided among the shareholders, the depositors and the government. Since the sum of the mudarabah shares must add up to 100 per cent, it begs the question what should be the share of the state which has not injected funds of its own into the commercial banking operation? Does this mean that the share of the state can be fixed arbitrarily and varied at will? Does not this amount to taxing the incomes of commercial banks? If so, are we not really speaking of fiscal measures rather than monetary economics proper?

Dr. Chapra carefully mentions the various pros and cons of these alternatives, without committing himself to any one of these. It will be of interest to know which of the two he really opts for and why.

Of the various monetary instruments discussed in Dr. Chapra’s stimulating paper, the suggestion that a maximum of 25 per cent of the demand deposits of the commercial banks be earmarked for providing interest-free loans to the government, deserves a special mention. The novelty of this proposal lies in that this source of financing, which is interest-free, is not costless, as the government, will have to bear at least 25 per cent of the total cost of mobilizing the demand deposits and rendering services related to these deposits and the cost of deposit insurance. This is certainly a non-inflationary way of financing government expenditures, unlike his other suggestion that a part of the MQ created by the central bank is made available to. the government.

As mentioned earlier, Dr. Chapra restricts the statutory reserve requirement of 10-20 per cent to the demand deposits only without extending it to cover other deposits as well. His argument is that the mudarabah deposits, which constitute a part of the equity in an Islamic economy, should not be subject to any reserve requirement, unless similar requirements are imposed also on other forms of equity. I think that it is important here to make a distinction between mudarabah deposits and other forms of equity. Mudarabah deposits in a banking system play a more crucial role than direct equity participation elsewhere in the economy. Hence, there is no basis for equating the two in considering the merit of the statutory reserve requirement. I also think that the statutory reserve requirement against mudarabah deposits is far more important than that against the demand deposits. The commercial banks normally hold a large proportion of the demand deposits in liquid form, as these deposits can be withdrawn at any moment. Since the twin purposes of the statutory reserve requirement are to ensure that the financial institutions remain reasonably liquid and that they do not over-expand credit, such a statutory requirement becomes all the more important and necessary for the mudarabah deposits. Since the mudarabah deposit cannot be withdrawn immediately, the banks will tend to commit these funds on long-term projects which are profitable at the expense of liquidity considerations. In such circumstances, the statutory reserve requirement against the mudarabah deposits will force the banks to keep a part of these deposits in liquid form and limit their scope of credit expansion.

With regards to the 10—20 per cent statutory reserve requirement against the demand deposits, Dr. Chapra’s suggestion is that the central bank should invest these funds to derive income for covering its expenses. In the present-day set-up, the central bank invests such funds in interest-bearing government securities which can be easily converted into cash. But, in an Islamic economy where such interest-bearing securities are out of question, what alternatives are really available to the central bank for investing these funds, without jeopardising the liquidity of the reserves? I am thus inclined to think that investing these funds is not as simple as Dr. Chapra seems to suggest.

The other suggestion of Dr. Chapra that “the central bank does not invest these funds directly but makes them available to commercial banks and other financial institutions on the basis of profit-sharing” is even more objectionable on a number of grounds.* First, it will imply that the central bank relinquishes its control on how these funds should be invested, thereby totally disregarding liquidity aspect, which in my opinion is of over-riding importance in the case of such reserve funds. Second, to make these funds available again to the banks will defeat the very purpose of the statutory reserve requirement and will amount to a dilution and even a negation of the monetary control implicit in the instrument of statutory reserve requirement. Third, it is morally wrong for the central bank to enter into profit-sharing arrangement with the commercial banks using funds that really belong to the latter.

The statutory reserve requirement can be a powerful instrument of monetary control, and its importance to the Islamic monetary system, where the instrument of interest rate is not permissible, is readily obvious. Extreme care should, therefore, be exercised so as not to blunt the statutory reserve ratio instrument in any way.

There are a number of other monetary instruments which have not been mentioned in Dr. Chapra’s paper. These instruments were discussed in the Mecca Seminar in October 1978. These include: (a) “refinance ratio” which refers to the central bank’s refinancing of a part of the interest-free loans provided by commercial banks, (b)“qard-hasnah” ratio by which is meant the percentage of demand deposits that commercial banks are obliged to lend at an interest- free loan, (c) “profit-sharing ratio”, which forms the basis on which mudarabah investments are to take place between the banks and the clients in the economy, and (d) the ratio of interst-less government securities in the advances portfolio of financial institutions. All these ratios, which can be varied or adjusted by the central bank in such a way as to regulate the money supply, represent potent instruments of monetary control in an Islamic economy.

Finally, Dr. Chapra does conclude that monetary policy will be asymmetrical in its impact, since it will not be as effective in a recession as in an inflation. This leads him to suggest that the government should offset deficiency in aggregate demand by undertaking fiscal deficits financed by an increase in the supply of MQ. That fiscal measures are more effective than the monetary ones in overcoming recessions has been acknowledged not only by the Keynesians but also by the Monetarists themselves. Nonetheless, it may be in order for us to question whether the monetary policy in an interest-free Islamic economy will be as weak as that in an interest-ridden capitalist economy in times of recession. The current weakness of the monetary policy as an anti-recessionary device may be attributed to: (a) interest inelasticity of investments, and (b) passive role played by the financial institutions. But, in an Islamic economy, interest is no longer a cost to the entrepreneur and the risk borne by the entrepreneur in times of recession is much less under the mudarabah system than in the capitalistic order. Thus, entrepreneurs in an Islamic economy will be less cautious and more adventurous even in times of recession than their counterparts in the capitalist system. Moreover, the financial institutions in an Islamic framework play a more active role than do their counterparts elsewhere. As we all know, the financial institutions in an Islamic economy are envisaged to take on an entrepreneurial role by being a partner in mudarabah investments, quite unlike the present- day financial institutions which merely provide funds for investment. It is in this sense that the Islamic financial institutions can be expected to lead the business community and actively influence the business outlook by injecting confidence and stimulating investments in times of economic downturn.

My final comment relates to the speculative demand for money. The author seems to completely dismiss the speculative motive out of consideration in an Islamic system. I think that speculation of all kinds is not un-Islamic. I do not think that there is anything wrong or un- Islamic for me if I vvant to have my assets in a liquid form if I think that it is not the best time to buy property. If I could buy it next month may be I stand a better chance of profit. This is really speculative motive for holding money and I do not think there is anything un-Islamic about it. So in my view the speculative motive should be taken into account in formulating the demand function for money.

I believe that my comments do not in any way undermine the value of Dr. Chapra’s paper which undoubtedly is an excellent piece of work. I do hope that the criticisms offered here will provide further impetus for the author in his relentless efforts to formulate a workable and meaningful monetary policy framework for an Islamic economy.

Dr. Mohamed Ariff


Dr. Umer Chapra’s paper, “Monetary Policy in An Islamic Economy’’ is a useful contribution to the literature on Islamic Economics. It addresses some very important theoretical issues and policy problems. It also contains concrete policy proposals to solve the problems discussed. However, this is not to suggest, that the paper is the last word on the question of monetary policy in an Islamic Economy, nor is it to say that every word of it is correct. In my view the contribution of the paper is to identify the real issues and to set the state for further debate and research by providing policy recommendations which in his view will resolve the problems. One may disagree with any of his proposals or add new dimension to it but the fact remains that Dr. Umer Chapra has provided enlightening ideas and exciting proposals.

In the section on the goals of monetary policy in an Islamic eonomy he enumerates three goals namely: full employment and high rate of growth; socio-economic justice and equitable distribution of income; and stability in the value of money. As the author notes these objectives appear on the face to be the same as those of capitalism but there are fundamental differences in their interpretations. The author adequately explains those differences. What the paper lacks is, in my view, a discussion of the relative importance of various objectives.

There is one supreme objective of all economic activity — rather all human activity — that is to maximize human welfare. The various objectives enumerated are simply the “means” or “semi-objectives” and not the ultimate “goals”. The concept of welfare is different in different systems and hence the importance or “weight” of the different tributories to the ocean of welfare will also be different. This difference in emphasis is one of the things that distinguish one system from the other. It is well known that these “objectives” are not always compatible with one another. There are many trade-offs involved and the “rate of substitution” of one objective for the other depends on the social and ethical values of the society.

In the same ^section the author raises a very interesting question i.e. the position of inflation in an Islamic economy. The author states* that “any continuous and significant erosion in its (money’s) value should be interpreted in the light of Islamic teachings to be tantamount to “corrupting” the world because of the adverse effect this erosion has on social justice and general welfare”. The quotation is undoubtedly true but this does not give inflation position which is much different from its position in other systems. What makes inflation really repugnant to the Islamic economy is the fact noted later, that is inflation conflicts with riba-free economy because inflation involves injustice to the riba-free lender by reducing the real value of the amount he has lent. The question is how to avoid any injustice to a person advancing a goodly loan (qard-hasanah). The author suggests that price stability is the best answer. Sounds great: However, when it comes to practice it possesses many problems. In this regard I would request the learned author to elaborate a few points. Firstly, what is his interpretation of price stability? Usually a mild rate of inflation (2—3 per cent) is not considered to be incompatible with price stability. Should the author accept this definition, then the question of injustice to the riba-free lender rises again. Islam prohibits injustice irrespective of its degree. On the other hand if he implies zero rate of inflation, then, is he recommending absolutely rigid prices? If so, would not it be harmful for the investment activity? More importantly, how would the government achieve a zero rate of inflation? In today’s work most of the inflation in less-developed countries is of foreign origin which is not easy to control by domestic policies. Thus, if the objective is to avoid injustice to any party, would it be permissible to “index” loans to the extent that inflation persists.

Now I come to what I consider to be the most important contribution of the paper. This is the section dealing with the public share of demand deposits. Because of the immense practical importance, the issue may become a subject of considerable debate. I will, therefore, deal with it at some length.

Let me start by recording my broad agreement with the proposal. I have some differences with regard to its implementation which are noted later. I fully endorse the view, that since the funds available through demand deposits belong to public, a part of the benefit should go to the public.

Under multiple credit creation the banks receive a regular flow of resources which may be called “seigniorage”, by analogy to the resources which used to accrue to sovereign rulers of the past who had the right to mint coin with a face value larger than the intrinsic metal value in the coin and the cost of manufacturing etc. The present value of the social seigniorage (SS) arising from the issue of D units of credit money is equal to:

SS = R – C               R – C  + R – C            xD

   1+d                (1+d)2        (1+d)n_

Where n is the period at which the paper money has to be “retired” or is replaced by a commodity substitute; R is the marginal social productivity of the resources; C is the social unit cost of servicing the fiat money, (if interest is paid on deposits then that will be included in C) and d is the social discount rate.

In reference to the capitalist economies, it is maintained that this seigniorage gets distributed to the depositors through the payment of interest on deposits and through other banking services. Specifically, assuming n to be infinite.

ss = (R-r-C)D d

Where r is the rate of interest on deposits and if r = R — C then SS = 0. It is claimed that competition among the banks will assure that r approaches (R—C). There are two problems with this solution. First, historically banks have been earning extra-ordinarily high profits. This is because it is very difficult to achieve competitive conditions in the banking industry. Secondly the payment of interest is out of question in an Islamic economy. Now it is possible to pay out mudarabah share instead of the rate of interest but the nature of demand deposits is such that the holders either need immediate liquidity or they are risk-avert.

In both cases it is not possible to invest them on profit-sharing basis. The alternative is to divert these resources to the government which can spend it in accordance with social priorities. Thus the author’s proposal makes a lot of sense.

Another advantage of the scheme is that making the public share of demand deposits a variable provides the authorities with another policy tool which may be valuable in the absence of some other policy tools available to the monetary authorities in a riba-free economy. In this regard I do nokquite understand the author’s recommendation* that in a period of recession, the government may use a higher proportion than that in conditions of full employment. In my view it should be exactly the opposit. A higher percentage will have a contractional effect since the money multiplier will be reduced. In its effect on money market, the public share of demand deposits is similar to statutory reserves and in recession we reduce the statutory reserve requirement, not raise it.

A related point is that apart from any counter-cyclical manipulation the rate of the public share of demand deposits should not be very high because the higher the share of government in demand deposits, the lower will be the money multiplier. This is critical because the profit-sharing system which will replace the present riba-ridden system, already involves under-expansion of credit for many reasons. These include: (

   (i) The ratio of demand deposits to total deposits will increase, since the perfect risk averters will put their savings in demand deposits;

  1. The demand by banks for “excess reserves” may increase because of the greater uncertainty under the profit-sharing system, since deposit variations arising from cyclical change will increase; and (iii) Loaning operations of the commercial banks will also be limited since considerable loaning is at present done on a riskless basis, which allows the commercial banks to maximize profits and to decrease their demand for liquidity.

In the framework of the paper under discussion, the provision of enough money will necessitate printing more money which will have an inflationary effect. Elsewhere in the paper the author has very effectively made a case against inflation in an Islamic economy.

Another point on which I would beg to differ with the learned author is his assertion that the proposed model would not seriously affect the profits of banks.T I feel that it would. This is nothing to be regretted, however. Rather I consider it to be another attractive feature of the model. In view of the extraordinarily high profits of the banking industry it is very much desirable to siphon off excess profits of the bank and distribute them to the poorer sections of the society. The scheme is thus in line with the equity objective of the Islamic economy.

To sum the discussion on public share of demand deposits, I feel that the proposal is very useful. It provides the monetary authorities with a much needed tool and the government with much needed funds. The rationale for the scheme is well justified. However, the implications of the proposed scheme for money multiplier call for a cautious approach in determining both the level and the counter-cyclical variation of the public share.

In the end I would like to suggest a few extensions of the present analysis which should be considered by the author and other researchers in the field.

Firstly, it should be investigated how the suggested policy proposals will affect the “real” sector of the economy. In a capitalist economy the monetary policy affects the real sector only through the rate of interest. In an Islamic economy the rate of interest will be replaced by the rate of profit. The rate of profit, however, depends on the business conditions. Thus the saving, investment decisions in an Islamic economy would not depend on the rate of interest but only on the expectations about business prospects. How, then the monetary policy will have any bearing on the real sector? (Incidently the achievement of a desirable rate of growth would depend on this.)

Secondly, the nature of the mudarabah advances of the central bank and their role in the management of the monetary policy should be explored in greater detail. Suppose there is an excess demand for liquidity for whatever reasons, e.g. crisis of confidence, change in expectations etc. The discount window is not available to the banks. They approach the central bank for additional funds. On what terms will the central bank make funds available to them? Since the commercial banks would not be investing these funds, the question of profit- sharing does not arise. For another example suppose there is recessionary trend in the economy. The central bank wants to follow an expansionary policy. In the framework of the present paper, it offers more funds to the commercial banks. Would it solve the problem? Obviously not. The problem in a recession is not that commercial bank do not have funds to lend. The problem is that people are not willing to borrow due to slack business expectations. What role, then the mudarabah advances can play and how?

Thirdly, some analysis is required to determine the implications for monetary policy of the replacement of interest-bearing assets by non- interest-bearing assets. In an Islamic economy securities, treasury bills, bonds debentures will all have to go. The predominant asset will take the form of equities. Now equities have different characteristics than the securities. The change will, therefore, have important implications for the conduct and effectiveness of monetary policy as well as the working of the other monetary institutions.

Dr. Munawar Iqbal


Source: Money and Banking in Islam, Ziauddin Ahmed; Munawar Iqabal; M. Fahim Khan. Republished with permission.