Objectives & Instruments of Monetary Policy

The papers presented at the Seminar identified three major objectives of monetary policy in an Islamic economy, namely, stability in the value of money, economic well-being with full employment and optimum rate of economic growth, and promotion of distributive justice. Al-Jarhi emphasises that it is almost mandatory on the central bank of an Islamic economy to preserve the value of money and suggest, in this context, that the central bank should allow expansion of money supply only to the extent it is justified by a possible contribution to growth in real balances. Chapra is also of the view that stability in the value of money should be accorded high priority in the Islamic frame of reference because of the unequivocal stress of Islam on honesty and fairness in all human dealings and because of the negative impact of inflation on socio-economic justice and general welfare.

While inflation is incompatible with the goals of an Islamic economy, prolonged recession and unemployment are also unacceptable. Monetary policy has therefore to aim at a high rate of economic growth with full employment. Chapra, however, clarifies that maximisation of economic growth per se is not the objective of monetary policy in an Islamic economy. He emphasises that the requirement to attain material prosperity within the framework of Islamic values necessitates that it should not be attained through the production of inessential and morally questionable goods and services, should not lead to an excessive and overly rapid use of God-given resources at the expense of future generations and should not harm present or future generations by degenerating the moral or physical environment.

Most participants were of the view that monetary policy should be used actively to promote the goal of distributive justice in an Islamic economy. Ariff, however, was of the view that too much concern with distributive justice in formulating and implementing monetary policy may adversely affect its overall efficiency and effectiveness in attaining other goals of monetary policy. Ariff too, like other participants, subscribed to the view that reduction in income inequalities should be an important policy objective of an Islamic state but felt that instead of over-burdening monetary policy by assigning to it too many objectives, the goal of distributive justice should be achieved by activating other policy tools. In making this suggestion Ariff referred to the well known Meade-Tinbergen principle that the number of policy instruments should be equal the number of policy objectives; otherwise, there may be conflict of policy goals. The general feeling in the Seminar, however, was that it is difficult to follow the Meade-Tinbergen principle too faithfully in actual practice, and that an attempt has to be made to so chisel the monetary policy that, along with other policy tools, it makes an important contribution to the attainment of the goal of distributive justice.

The Seminar gave careful attention to monetary policy instruments that could be used in an Islamic economy to achieve the stated policy objectives. The general feeling was that abolition of interest, and the non-availability of the Bank Rate weapon to the central bank, would not constitute any serious handicap to monetary management in an Islamic economy. It was pointed out that control over the volume of money supply is a crucial factor in monetary management. Adequate control could be exercised on money supply in an Islamic economy by regulating high powered money, defined as currency in circulation and reserve assets of banks. Besides, use could be made of variations in cash reserve ratio, liquidity ratio and credit ceilings to bring about desired changes in money supply. Apart from controlling money supply, monetary policy is also capable of being used to influence the allocation of resources. In the interest-based system, variations in interest rates and policy-induced differentials in interest rates perform an important allocative function. This role could be performed by changes in profit-sharing ratios in an Islamic system. The actual manner in which the various monetary policy instruments may be used in an Islamic economy is discussed in the next section.

It was emphasised that the allocation of bank resources in an Islamic economy should be value-oriented to help realise the goal of general social welfare. Both Al-Jarhi and Chapra express dissatisfaction with the manner in which bank resources are utilised in the capitalistic system. Al-Jarhi points out that in the interest-based banking systems operating in capitalistic countries, solvency of the borrowers is a paramount consideration while the productivity of the investment undertaken is considered secondary. Chapra expounds the view that the monetary and banking arrangements in capitalistic countries tend to generate income inequalities because “society’s resources mobilised by banks are utilised by them for enriching a few families.” He, therefore, pleads for reduction in the financial power of banks. This, he feels, could not be achieved by the apparently simple expedient of nationalising the banks because “the place of businessmen and industrialists could easily be taken over by bureaucrats”. He feels that the solution lies in: (a) having a larger number of banks and ensuring that none of them expands beyond a certain limit determined by the central bank of the country; (b) requiring the banks to provide financing to a larger number of entrepreneurs and limiting the provision of finance to any one business or family to a small proportion of banks resources; and (c) disallowing the inter-locking of directorates of banks and big business firms. Besides, special measures as deemed necessary may be taken by the central bank to bring about a more equitable distribution of bank finance. These could include inducement mechanisms, such as central bank introducing loan guarantee schemes to reduce the risk of financing in certain sectors, and compulsive measures such as setting of mandatory targets to ensure sufficient supply of bank resources for specified sectors or purposes.

Al-Jarhi goes a step further. He favours imposition of a 100 per cent reserve requirement on commercial banks. He justifies this on three grounds. Firstly, fractional reserves cause the monetary system to suffer from an “inherent instability” because any switch from “high powered money” to “deposit money” and vice versa changes the supply of money. With 100 per cent reserves such a switch will change only the composition of money, leaving its total supply constant. Secondly, changes in the money supply arising from deposit creation or resulting from substituting deposits and cash make it more costly to maintain the existing stock of real balances or to add to it. Thirdly, money creation is a social prerogative and hence the benefits of the process of money creation should accrue to the whole society which can best be achieved through 100 per cent reserve system.

Al-Jarhi outlines a model with 100 per cent reserve system in which the liquidity and financial requirements of the private business sector will be rngt by the central bank opening deposit and investment accounts in commercial banks and other financial institutions which in turn will invest these deposits in the real sector and share the profit with the central bank. Variations in the central bank’s deposit accounts with the commercial banks will have the effect of bringing about the desired changes in money supply.

While there was general agreement with regard to the objectives of monetary policy in an Islamic economy as outlined by Chapra and Al-Jarhi, doubts were expressed by some participants whether replacement of the present monetary institutional framework by an entirely different model was absolutely necessary. Ziauddin Ahmed was of the view that problems of instability and inequity could be solved within the framework of the fractional reserve system. If there are suitable checks and balances, the process of money creation need not be unstable. Further, even in the fractional reserve system measures can be adopted to ensure that the allocation of derivative deposits is such that the benefits are equitably distributed. It seems that this is an area in which there are genuine differences of opinion among Muslim economists and further exchange of views would be fruitful.

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