The Role of Monetary Policy

There can be no question that monetary policy in an Islamic economy should not only be in conformity with the ethos of Islam but should also help realise the socio-economic goals that Islam emphasises. Some of the most important goals may be briefly stated as:

1. Economic well-being with full employment and optimum rate of economic growth;
2. Socio-economic justice and equitable distribution of income and wealth; and
3. Stability in the value of money to enable the medium of exchange to be a reliable unit of account, a just standard of deferred payments and a stable store of value.

It may be argued that the goals of monetary policy in the Islamic economic system, as stated above, are the same as those of capitalism. Such a statement would not be correct because even though there may be an apparent similarity; there is in fact a significant difference in emphasis arising from the divergence in the commitment of the two systems to spiritual values, socio-economic justice and human brotherhood. The ensuing discussion should make this point clear.

Economic Well-being with Full Employment and High Rate of Growth

The inevitable outcome of the Islamic belief that human beings are the vicegerents of God, is that they must lead a life that befits their status. The Divine Guidance embodied in Islamic teachings is intended to help them in the realisation of this objective. Muslim jurists have unanimously held the view that welfare of the people and relief of their hardships is the basic objective of the Shari‘ah. This view would, in the economic field, necessitate economic well-being through satisfaction of all basic human needs, removal of all major sources of hardship and discomfort, and improvement in the quality of life, morally as well as materially. Hence full and efficient employment of human resources would be an indispensable goal of the Islamic system, because it would help realise not only the objective of broad-based economic well-being but also impart to human beings the dignity demanded by their status as God’s vicegerents. Full and efficient employment of material resources would also be an essential goal because, according to Islam, all resources in the heavens and the earth are meant for human welfare and need to be exploited adequately, without excess or wastefulness, for the purpose for which they have been created.

While a reasonably high rate of economic growth should be the natural outcome of policies leading to full and efficient employment of human and material resources and to broad-based economic well-being, the high rate of growth is by itself not of prime importance. This is because the requirement to attain material prosperity within the framework of Islamic values requires that it should not be attained through the production of inessential or 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 who are equal owners of these resources, and should not harm present or future generations by degenerating their moral or physical environment. Hence, while full employment and material well-being are essential in an Islamic context, a high rate of growth is only essential to the extent to which it contributes to full employment and broad-based economic well-being. Beyond this, its importance would have to be carefully weighed against all its other implications.

Socio-economic Justice and Equitable Distribution of Income and Wealth

The goals of socio-economic justice and equitable distribution of income and wealth are an integral part of the moral philosophy of Islam and are based on its unflinching commitment to human brotherhood. The capitalist system’s conversion to socio-economic justice and equitable distribution of income is, on the contrary, not based on a spiritual commitment to human brotherhood; it is rather the outcome of group pressures. Accordingly, the system as a whole, particularly its money and banking arrangement, is not geared to these goals and glaring disparities of income and wealth continue to be generated. Nevertheless, because of the influence of socialism and political pressures, some of these inequalities are being partly reduced by taxation and transfer payments. In contrast to this, Islam tries to uproot the causes of gross inequalities at their source and also uses Zakah, taxation, and transfer payments as additional measures to reduce inequalities even further to bring about a distribution of income which is in conformity with its concept of human brotherhood. Hence it is essential that even the money and banking system and monetary policy are so designed that they are finely interwoven into the fabric of Islamic values and contribute positively to the reduction of inequalities.

Stability in the Value of Money

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. It has been suggested that in the current world-wide inflationary climate, the Islamic imperative of socio-economic justice could be satisfied by indexation, of all incomes and monetary assets including qard-hasanah - loans extended without interest or profit-sharing.

While indexation might help ameliorate partially the inequities arising from inflation, it is not a cure for inflation. It may, in fact, tend to accelerate inflation and be self-defeating unless inflation is on the decline and remedial monetary, fiscal and incomes policies are being adopted. It seems, therefore, that while indexation could be examined as a temporary sedative for the pain of inflation, the policy alter- native which would best conform to the norm of socio-economic justice in Islam is price stability and not indexation. However, it is important to note that indexation has so far not received the blessing of any school of Muslim jurisprudence.

While inflation is in conflict with Islamic values, prolonged recession and unemployment are also unacceptable because they bring misery to certain sectors of the population and also act counter to the goal of broad-based economic well-being. Recession also tends to increase uncertainty and discourages investors from undertaking risk associated with projects that earn a return over many years. Hence, in the interest of achieving overall objectives of Islam, it would be necessary for the Islamic state to adopt all available measures to minimise economic fluctuations and to stabilise the value of money.

A generally accepted principle in capitalist economies is a trade-off between unemployment and inflation. In the context of Islamic values the concept of such a trade-off is questionable. While inflation is iniquitous and against the interest of long-term well-being, unemployment of human resources is inequitable and not only conflicts with dignity of God’s vicegerent but also vitiates the realisation of equitable distribution of income. One may also question whether it is necessary to have inflation to achieve full employment and whether it is essential to have unemployment to avoid inflation.

In the Islamic system both unemployment and inflation are undesirable, and both need to be eschewed. If aggregate demand is to be contained or lowered to avoid inflation then in the overall interest of social justice and broad-based economic welfare a value judgement needs to be made about what kind of demand should be contained or reduced and how best this can be attained. In a value-oriented system it would be indefensible to allow demand to expand in inessential directions to attain a high rate of economic growth and, if this generates inflation, it would be equally indefensible to try to control it by reducing aggregate demand in a general, across-the-board manner by creating human unemployment. Similarly, full employment must be ensured even if this demands a restructuring of production and designing of suitable technology. It would be essential to regulate aggregate demand, restructure production, design a suitable technology, and develop an appropriate mix of monetary, fiscal and incomes policies to avoid both inflation and unemployment, and to ensure broad-based economic well-being for adequately satisfying the essential needs of all individuals in keeping with Islamic teachings.

Achievement of the whole range of objectives mentioned above would require a fundamental reform of the entire economic system including its money and banking framework. The reform of the latter would include the abolition of riba and the reform of banks to minimise their financial power and their role in skewed income distribution. It would also include a change in the strategy and instruments of monetary policy aimed at regulating the expansion of overall credit in accordance with the non-inflationary needs of the economy as well as the value-oriented allocation of credit to attain the desired socioeconomic goals of Islam. It is with the strategy and instruments of monetary policy that the following discussion will be concerned.

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