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Discussion on Monetary Policy in an Islamic Economy

Before I ask for comments, I would like to highlight some of the areas in which it will be useful to have comments, rather than repetition of the arguments already made. As you may have noted, there are a few areas of disagreement between the author and the discussants. One is that monetary policy should not be over-burdened with too many objectives. The second is on the question of indexation. The third point is whether or not in Islamic economic system there are valid reasons for having speculative demand for money. Another important point for further discussion is whether the methods suggested for financing government deficits, particularly by earmarking 25 per cent of the commercial bank demand deposits, is really the right way to go about it and whether it makes any substantial difference or not. Finally, the assertion that the Islamic monetary policy plays a more active role in a period of recession. I would suggest that these points should be given a greater weight in the ensuing discussion.

Chairman (Dr. Ziauddin Ahmed)

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About the goals stated by Dr. Chapra, I would like to know what is the authority from the Shari‘ah in support of these objectives, because some of the Western writers have said that recently Muslim thinkers have started saying good things about social justice, full employment and distribution of income. They say that these ideas have been borrowed from the West. I want to know the reference from the Shari'ah.

M. Akram Khan


In an Islamic economic system, the function of money is essentially as a medium of exchange rather than a store of value because Islamic economic system is essentially an expenditure-oriented system. The moment we consider money as a medium of exchange rather than the store of value, we can easily see that indexation may not be necessary to compensate for inflation.

Agha M. Ghouse


I have two short comments. First is on Indexation. In this regard I want to bring your attention to two points: First, the alternative use of the money lent. If the alternative is to keep it in demand deposits or in the money form, then we are not doing any injustice to the lender. The second point on indexation is the saying of the Holy Prophet (Peace Be Upon Him) on the matter which is called by the Fuqaha, Riba-al-Fadal, wherein the difference in value of the same quantity caused by time is not recognised. Even with a time lag no additional quantity should be given. The second point that I have, is concerning the speculative demand. The author recognises the possibility of the Islamic central bank using open market operations. He should then, recognise with it, the speculative demand, because open market operations imply the speculative demand of the other party in that transaction.

Dr. Monzer Kahf


I would like to draw the attention of Dr. Umer Chapra to three problems. One is how to define the area for inessential investment. This will be decided by investors, whether they are private or public. If there is emphasize upon solving the problem of unemployment, there can be some field of investment where the main aim could be creation of more employment. This is why the definition of inessential investment poses problems.

Another problem is that there are many people who do not have any deposits in the bank. How to compensate those people for inflation? This is why I think that instead of indexation it is better to use other tools of social policy like raising of wages and salaries or raising the pension when the inflation rate is high. Finally, I am doubtful whether it will be useful to give the government the right to have 25 per cent of the demand deposits of commercial banks. It is better to keep the government out of the banking system as far as possible. Another related question is that when will the government return that 25 per cent? In abstraction the model may sound very well. But in practice what will happen is that after one year or two, the government will say that we are not paying back the 25 per cent borrowed.

Dr. Nevzat Yalcintas


1 do not think that Dr. Chapra is over-burdening the monetary policy by having multiple objectives. We should look at these objectives as the objectives of government policy and what he is trying to show is what role monetary policy should play in achieving those and he is correct in that. My second point relates to the matter of finding resources to finance government activity. I think if Zakah is properly collected, it would not be necessary for the government to resort to deficit financing. His suggestion of diverting 25 per cent demand deposits to the government, means that he is accepting the government deficit as a means for achieving economic objectives. But I think deficit financing is the main source of the rate of inflation that we are experiencing. If we make more resources available to the government, this will aggravate the situation of inflation further.

Thirdly, about speculative motive, I would like to agree with Dr. Ariff. I think in Islamic economy, the speculative motive will still exist. What might be the reason for some of us not accepting the speculative motive, is that when Keynes was talking about the liquidity preference he compared money as a store of value with bonds and bonds are not permissible in Islam. But this does not mean that this is the only form of assets which should be considered. You may very well hold money till you have a more appropriate asset to invest in and this is speculative motive. As for Zakah and its effect on speculative demand, I do not agree that the Zakah would reduce the speculative demand. Zakah will be imposed on assets which are lying idle for one full year. It will not be imposed on deposits which are lying idle for less than one year. On the question of indexation, I disagree with Monzer Kahf. Actually, indexation makes more justice because we are trying to return the same purchasing power and this is also implied by so many Ahadith and by the principle of Islamic justice.

Dr. Sultan Abu Ali


In case of indexation, shall I assume that you would be just talking about indexation in terms of the value of money and ignoring the indexation of income and prices which also play a rather integral role in any economic system including the Islamic economic system. Secondly, I have an observation with respect to the speculative demand for money. Is it because we do not know enough about the nature of risks and uncertainties involved in the speculative demand that this aspect has completely been ignored by Dr. Chapra?

My third, observation relates to the role of investment which the central bank will probably assume, (i) What will happen to the decisions that would have to be taken in terms of various types of portfolio investment if any? (ii) What will be the role of the central bank in terms of getting involved into some very sophisticated industrial investment decisions? I assume that if that happens to be the case then a certain amount of technological expertise would be required either in the central bank, or in the commercial banks where the investment decision have to be ultimately taken.

Dr. Syed Aftab Ali


The paper by Dr. Chapra is an excellent one. I would like to mention three important points which were well argued in the paper, before I take exception to another point. First, the multiplicity of the objectives is crucial and should be kept in the forefront all the time.

The second important point is the idea that the central bank can provide finances to commercial banks through mudarabah advances. This answers the question of how can we affect the supply of money without interest-bearing instruments. Another significant point is the question of financing part of the government deficit. Here, I think what Dr. Chapra should have said is that we can make use of a certain proportion of the growth in deposits to finance government deficit. Deficit is a flow, whereas deposits are stocks. So only the growth in the stock of deposits can finance part of the government deficit on a permanent basis.

The exception I want to take is about the question of indexation where a satisfactory treatment requires a separate paper. An Islamic position on indexation can be reached only after careful assessment of its economic implications in the light of both Shari‘ah principles and the alternatives to indexation. Regarding alternatives, it is worth remembering that Shari‘ah permits interest-free loans in kind where repayment is also made in kind (an equal quantity of the same commodity). Another alternative to indexation of loans is to facilitate real investments in small units through suitable kinds of mutual funds. The assets of such funds are well diversified in real investments or in shares of productive enterprises. Such assets usually appreciate during inflation. This is entirely acceptable in SharVah (whereas outright general indexation of loans is not — as far as I know) and should be seriously considered by those who claim that permitting interest is the only way to protect the small saver. More research is required in this area, and I hope Dr. Chapra and other competent Muslim economists and jurists would scrutinise the issue.

Dr. Anas Zarqa


I have a couple of points to make. First of all, the question of indexation, the Fuqaha do not accept it generally. However, as Dr. Anas Zarqa has pointed out loan in kind is acceptable. So that may be one possibility. As for the definition of inflation, I think a mild rate of inflation may be acceptable in an Islamic economy but we must try to minimize it since a high rate of inflation involves injustice to the lender in an interest-free system. Multiple credit creation by banks also leads to inflation. As a matter of fact less than 100 per cent reserve requirement is not permissible in the Islamic economic system.

Dr. Omar Zubair


I have three points. First, the rate of interest in a capitalist economy performs the function of achieving equilibrium in the money market. In Islamic economy there would not be interest. How would we achieve equilibrium in the money market? The rate of profit would not do it. We have to find some other alternative. My second point is that in Islamic economy there would not be any short-term bonds. Some substitute is required. Finally, I agree with the view that speculative demand for money can exist in an Islamic economy.

Dr. M. M. Metwally


My first point is that indexation is justified in Islamic economy. It will protect the value of money and bring more justice to the lender in an interest-free system. Secondly, a view was expressed here that in Islamic economy, money has only a medium of exchange function. I do not agree with that. I think there is also a store of value function for money in an Islamic economy. Also, there is a role of speculative demand for money.

Dr. M. A. Mannan


Both Dr. Munawar Iqbal and Dr. Ariff have raised very thought- provoking comments. A big question that was raised by Dr. Iqbal is that we need to spell out the effect of money on the real sector of the economy in Islamic framework. This is a very important theoretical question. I will offer a very very small answer, though partial, building on the paper of Dr. Nejatullah Siddiqi. When the central bank decides to expand the money supply to provide more funds to commercial banks as mudarabah funds, the commercial banks will be willing to accept a smaller share to profit when they provide these funds to investors and that is how you can affect the real sector. The businessmen will realise more net profits even if the profit expectations are low. There is a financing partner who is willing to accept a lower profit share so the net profit accruing to the businessmen will be affected. Thus, we have a sort of uni-directional effect of monetary expansion on the profits of business.

Dr. Anas Zarqa


I want to draw the attention of the author to a fundamental fallacy in his paper where he talked of a trade-off between inflation and unemployment that he thinks is a characteristic of the capitalist economy, and which he does not like. I do not like it either, but it does not mean that it will automatically go away. In an Islamic economy the trade-off between inflation and unemployment will not vanish. What the author implies is a vertical Phillips curve, which will obtain in case of price rigidity, because price rigidity means perfect foresight. In practice, however, neither complete price rigidity nor perfect foresight is possible. So Phillips curve will have a negative slope and the trade-off between inflation and unemployment will exist.

Professor Syed Nawab Haider Naqvi


The experience of last 50 years shows that inflation is going to persist for quite a long time. In this condition of persistent inflation what would be the motivation for interest-free saver? My personal view is that the capital should be protected from inflationary erosion. Some kind of indexation would be necessary at least during transitory period.

Dr. Sharafat Ali Hashmi


There has been a discussion on multiple policy objectives. Hoping to do every thing with one policy is all right but the question is whether we are going to achieve the target or not? I agree with Dr. Ariff that we should use one policy instrument for one policy objective. I also agree with Dr. Munawar Iqbal that we should rank the objectives. My second point is concerning indexation. I think it is permissible in an Islamic framework. If we have a basket of goods and we use it as a means to index the loans then we will be able to protect the value of the loans over time.



There is a built-in element of indexation in an interest-free economy in case of fixed investment under muzarabah as well as under sharakah enterprises. This can be clearly seen in case of liquidation of the enterprise. For settlement of accounts in the event of dissolution of sharakah, the issue will be settled by the valuation of assets, and liabilities so as to determine the net realisable worth. This will have a built-in element of indexation. The problem of indexation in interest-free economy, therefore, mainly relates to working capital financing. If there is indexation in case of fixed investment how can we weed out indexation from working capital financing? To do so will be inequitable to the providers of working capital. Also in interest-free banking the general mode of muzarabah as well as sharakah will be that of transitive muzarabah and transitive sharakah between deposit holders and users of bank credit via financial mediation by banks. It is simple to see that banks will be protected by built-in indexation. This benefit must be passed on by the banks to the deposit holders. To do so will sustain the confidence of the depositers and encourage savings rate and also achieve justice by protecting the real value of savings.

Dr. Mahfooz Ali


I would like to make a point about the effect of monetary policy on unemployment. There is a kind of unemployment known as structural unemployment and this kind of unemployment is a very large segment of the unemployment picture. But neither monetary nor fiscal policy has an effect on this kind of unemployment. I would like the author to explain how will monetary policy in an Islamic framework improve the situation of structural unemployment. I think, what we need in that case is a manpower policy.

Dr. Masudul Alam Choudhry


I congratulate Dr. Chapra for his very illuminating and scholarly paper without repeating what has already been said. One point I would like to know from the learned author is whether in his opinion the present credit creating power of the commercial banking system will continue in the Islamic system? As we know, the commercial banks in the process of multiple credit creation, create money for which neither the banks nor their depositors make any sacrifice. By doing so the commercial banks exercise a power which should be a prerogative only of the state or its agent, the central bank. I think the suggestion for handing over to the government a percentage of the demand deposits is very much innovative. Now, if this is against the created deposits, government may not be liable to pay any service charge as prescribed by the learned speaker. Moreover, exact apportioning of the cost of mobilizing demand deposits may not be practicable either. As regards created deposits or the ‘derivative deposits’, the learned speaker has suggested to regulate this through controlling base money. As a matter of fact the main source of base money for the commercial banks is not the central bank, it is rather public deposits. The central bank’s regulatory power over the supply of base money by variation of reserve requirement and by denying or granting a loan to the commercial banks is recognised. In an Islamic system, central bank’s loans to commercial banks are supposed to be limited, as financial assets in general are likely to be risk-bearing and central bank’s involvement in risk-bearing financing may reduce its status as the regulatory authority. However, loans may be sanctioned against reserves with the central bank. In the present system it is an injustice to the borrowing commercial banks to charge interest while their money is lying idle with the central bank in the form of reserves. However, the reserve requirement is a strong instrument to control the size of money multiplier (m) provided the propbrtion of M held by public as cash remains constant.

In the Islamic system if the multiple is taken away by the government, the reserves with the central bank may be used for granting loans in emergency and for facilitating inter-bank transactions only.

Another point related to this is how the commercial banks in the Islamic system would utilize their current account balances. If the balance is utilized for short-term profit-bearing advances, then the depositors will have to bear risk which they may not be willing to do. If 100 per cent cash is maintained, the cost of transactions on current account may be too high for smooth commercial functioning. In the present system the real interest given to current account holders is sometimes more than the nominal interest given to saving depositors — this is what has been revealed by a survey made by the Guardian of London in 1971. Under these circumstances it may be worth considering that a certain portion of current account balances be utilized to meet the emergency withdrawal of PLS accounts and margin of benefit may be provided to even C/A holders. This will provide incentives to many to keep their balances with banks rather than keeping idle with themselves. As such this would provide a more favourable condition for central bank to control the overall monetary situation. My fourth point is related to maintaining the external value of currency, which is one of the very important objectives of present- day system. Monetary policy in Islamic framework cannot overlook this either. Moreover, in UDCs, internal value is also closely related to the external value of the currency. Today throughout the Muslim World we use dollar and sterling as our reserve currencies. It is a pity that the Muslim countries use U.S. dollar even for transactions among themselves. Thus the total demand for U.S. dollars appears more than what it is in fact. This puts them in an advantageous position to have their currency recognised as reserve currency and thus they can meet their international commitments simply by running deficit and thus exporting inflation to others. Muslim countries together have a very substantial balance of payments surplus. If all the Muslim countries could form an institution like Islamic Monetary Fund in line with IMF, I think most of our problems in international transactions would be solved even without resorting to very high interest-bearing SDR. I am sure, this would help us a lot towards stability in the value of money both home and abroad.

Dr. A. A. Rushdi


Previously we used to manipulate rate of interest to control the monetary sector and to control the money supply. Now it is exactly opposite, i.e. we control the money supply and that will take care of the rate of interest.

Dr. N. Vagar


1 want to emphasize the point whether or not we can assign more than one policy objectives to monetary policy. In some cases that may be possible. But sometimes there are policy crisis when you assign a number of policy objectives to one instrument. So it is imperative for us to identify the situations when such policy crisis can occur and what to do about these crisis. 1 want to emphasize the relationship between the right kind of policy objectives to the right kind of instruments. But that does not mean that you assign only one policy objective to one instrument. Monetary policy instrument can tackle more than one objectives at certain times. But the point 1 want to make is that some policy instruments are better suited to achieve certain objectives. Mundell has demonstrated that fiscal policy instruments are better suited to achieve internal equilibrium and monetary policy is better for achieving external equilibrium and if you pair them wrongly, you have an explosive situation where you move away from general equilibrium. Let us see what are the objectives which can be better tackled by monetary policy and what are the objectives which should be left for other policy instruments.

Dr. Mohamed Ariff


I am grateful for a number of comments which are extremely valuable and which I will certainly take into account. However, I must point out that some of the comments were not relevant because may be the speakers did not have the time to go through the paper before they made their comments and they relied only on the presentation that I made which was very brief. For instance, this point which Dr. Vagar raised about the shift in the monetary policy these days to the regulation of the quantity and the shift away from the rate of interest; this has been quite elaborately given in the paper and 1 did not bring it in the presentation because I assume everybody has studied this point. Now, of course, some of the points are certainly going to remain as points of dispute between us now and may be in future and this is something really healthy. We cannot create a unanimity on a number of points which have come up in the discussion.

I must point out the reason for the multiplicity of objectives and particularly my stress on the distributional aspect of monetary policy. This is because l\>elieve that the banking system has been one of the major sources of inequalities of income and concentration of wealth and unless monetary policy addresses itself to this subject, we will be just beating about the bush. We have to use the banking system for reducing inequalities and concentration of wealth. In the other two objectives there was no major disagreement. But I would insist that if we want to bring about equitable distribution of income in the Islamic economy, we have to tackle the major sources of these inequalities and we cannot do so without proper handling of the banking system. As to the stability of the value of money, I have stated prices stability as our ideal. How far can we achieve it, is of course a different thing. But we must try to check it. There are questions raised as to whether the mild inflation is good or bad and what are the safe limits. These are of course points which need to be given necessary attention. The fact is that it can mean different things at different times. There was a time when \ — VA per cent was considered to be mild but now in some countries even ten per cent may be accepted. Regarding the external value of money, it is generally realised that if you do not have inflation in the domestic economy, then the external stability in the value of money may not be a problem. Coming to Dr. Naqvi's point about Phillips curves; it is now generally realised that the emphasis, that he placed, is not right and in fact it has been empirically proved to be wrong. There has been a lot of discussion on this question and there have been periods in the past when there has been inflation or a rising rate of prices accompanied by rising rate of unemployment. So the validity of the Phillips curves has not been as secure as he tried to point out.

A question has been raised about the use of money for speculative purposes. I think if this concept is applied to the Islamic economy we are bound to get into a number of problems. One of the reasons for large volume of speculative funds available, is the unrealistic tax structure in a number of developing countries. The tax structure is such that it generates black money and this black money cannot be used for productive purposes. So the only use you are left for it is either to indulge in luxury consumption or speculation of various types, because it can only go in the areas where it is difficult for the government to detect. So if we want to talk in terms of these elements, we shall have to talk about removing these problems which our economies have created for themselves. Whether there is Islam or no Islam we have to solve these problems and then comes the question of applying the Islamic ideals to our economies which would take us even a step further towards our goals.

Dr. Umer Chapra (Winding up)


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