The Financial Market & Equilibrium

Alternative Uses of Money in an Interest-free Economy

In contrast to the interest-based system, an interest-free economy gives a minute role to the process of lending. Considering safety, CLCs ire quite good. They are also liquid, due to their encashability; but so is money. Yet, the rate of return on CLCs is negative.

To hold a barren asset, for a full period of one year, implies getting no yield while having to pay Zakah at a rate of 2.5 per cent. This means that the net rate of return on these assets is negative. This applies to money hoardings as well as CLCs. In general, it applies to all monetary assets, i.e. claims to fixed sums of money. Therefore, lending is not the “next best” alternative to investment.

In an interest-free economy, the investor considers placing his money into a CDC as the “next best alternative”. Diversification exercised in the management of CDs gives a high degree of safety. Specifically, it gives the lowest degree of risk for income-earning assets. CDCs with short-term maturities should be encashable with a notice that is shorter than on other income-earning assets. This places them next to CLCs in terms of liquidity.

Since central deposits are allocated to banks according to the efficiency criterion, their rate of return approximates the average rate of return on investment for the whole economy. It is, therefore, possible to say that this rate of return becomes in itself the opportunity cost of money.

This is an investment-centred economy. Investors consider the safest possible investment opportunity as their next best alternative. They do not consider the safest possible lending opportunity as such. In this way money and investment markets are effectively interconnected, for money holding is considered in relation to investment undertaking directly and not through a scheme of financial intermediation based on lending.

Speculative Demand for Money

People hold money for speculative purposes either when they expect prices to decline or they expect the rate of interest to increase. Both reasons, in an interest-based economy are inter-related. Expectations of lower future prices or higher interest rates will both lead to a shift from real and financial assets into money thereby causing a decrease in real asset prices and in bond prices which is equivalent to an increase in tlie rate of interest.

It. is true that investment behaviour in an interest-free economy replaces the rate of interest with the rate of return on CDCs. Yet, speculative demand for money should not increase with expectations of higher rate of return on CDCs. Such expectations would automatically be translated by the market into higher prices of investment instruments.

The rate of return on CDCs is used to discount the stream of future earnings of other instruments into their present values. When it is higher, the expected returns of such instruments must be higher, since the latter is some kind of an average of the former. Moreover, and for the same reason, the rise in the expected returns from investment instruments will always be higher than the rise in the CDC rate. The final result is not a decline but a rise in the prices of investment instruments. For similar reasons an expected decline in the CDC rate must be associated with a decline in the prices of investment instruments. However, expectations of such decline will not lead to a rise in speculative demand for money unless it reduces their rates of return to zero.

In an interest-free economy, prices should be stable, since monetary growth is tied to the rate of change in prices. Nevertheless if prices are expected to decline, because of say, some policy error, people would revert to money. They would sell some of their investment instruments and would hold cash or buy CLCs.

While the economy can adjust itself back to equilibrium through changes in the prices of investment instruments, the effects of a rise in speculative demand for money can be easily reversed through monetary policy. This is more effective since all monetary growth is automatically translated in CDs which flow through member banks to investors.

Market Equilibrium

From the above discussion, we can define the following functions:

S = S(p,Y)......................................................................... (1)

I = Ip(p) + Ig (P)..............................................................   .(2)

where S is savings, p is the rate of return on CDC of shortest maturity, Y is real national income, and I is investment. Superscripts p and g refer to private and government, respectively. Moreover,

Ig (P)           0 if P* > Mt

                       t+1

                      ifp6 < Mt

               >0    t+1

The above functions imply that savings depend on the average rate of return on investment as well as on the level of real national income. Meanwhile, private investment depends on the average rate of return12 and public investment depends on the rate of inflation. It should be noted that Ig is that part of government investment through money creation, which takes place only if the rate of inflation is expected to be lower than the rate of monetary growth as in (3). Equilibrium in the investment market would require:

S (p, Y) = Ip (p) + Ig (P)............................................................................................ (4)

Similarly, the mqney market can be described in the following manner:

Ms = Ms (p, P) I A Ms = 0 if P6 > Mt.....................................................................   (5)

t+l

>        0      if    P6    <  M

t+l

Md = Ml (p, Y) + Mc (p, P) .................................................................................... (6)

Ms (p, P) = M* (p, Y) + M° (p, P) .......................................................................   (7)

where Md and Ms refer to the demand and supply of money, M1 and Mc refer to transactions and speculative demand for money, respectively.

The supply of money equation reflects the mechanism of money creation outlined in Section I-d.

Transactions demand for money is made to depend on the opportunity cost of holding money, p, as well as the level of real income. Speculative demand for money depends, in addition to p, on the price level. Figure 3-b represents, equilibrium in the investment market, which started initially at pi. Given the demand for money and the price level, p1 determines the supply of money at M* in Figure 3*a which equilibrates the money market.

Now suppose the central bank increases the supply of money by AM. As the extra money is added to the flow of investment, and given the investment schedule, the rate of return declines to p2- This causes a decline of private investment by ab, which will be offset by government investment AM = be.

In the money market, the larger money supply will have caused, through extra investment, income to rise, shifting Md to the right. Meanwhile, the new money supply Ms + AM will equilibrate the money market at p2.

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