Download the optimal path of monetary expansion

THE ISLAMIC
MONETARY AND
FINANCIAL SYSTEM
Dr. Mabid Ali Al-Jarhi
6 June 2004
DR. MABID ALI AL-JARHI
1
MAJOR CHARACTERISTICS OF
CONVENTIONAL ECONOMIES
LENDING BASED VS
PRODUCTIVITY BASED
PROCESSES
6 June 2004
DR. MABID ALI AL-JARHI
2
RESOURCE
ALLOCATION TO
INVESTMENT
INVESTORS
DECISION
MAKERS
LENDERS
PRODUCTIVI
TY-BASED
TYPE OF
DECISIONS
LENDINGBASED
HOLDING REAL
ASSETS
ASSETS
HELD
HOLDING
MONETARY
ASSETS
FUND USERS’
6 June 2004
PRODUCTIVITY
MAJOR
DR. MABID ALI AL-JARHI
FACTOR
BORROWERS’
SOLVENCY3
The conventional Financial
Structure: Basic Characteristics
Lending based
 A significant amount of resources is handed
down from their owners to investors
through lending institutions
 Lending institutions maintain the claims
they hold against investors in the form of
monetary asset, rather than titles to real
assets.
 The process of money creation is lending
based

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DR. MABID ALI AL-JARHI
4
MONEY CREATION
COMMODITY MONEY
SUPPLY OF
GOLD &
SILVER
CONTROLLED
MONEY SUPPLY
IMPORT
OF GOLD
CURRENCY
DEBASEMENT
COINAGE OF
OTHER METALS
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DR. MABID ALI AL-JARHI
5
FIAT MONEY CREATION
NO LIMITATIONS ON
MONEY SUPPLY
RUNNING
INFLATION
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GOV’T
LENDING
EXPANSIONARY
OMO
EXCESSIVE
MONETARY
EXPANSION
HYPERINFLATION
DR. MABID ALI AL-JARHI
6
BASES FOR MONETARY CONTROL
EXCESS DEMAND
MONEY
HIGHER
PRICES
EASIER
TRANSACTIONS
LOWER
TRANSACTIONS
COSTS
GROWTH
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HIGHER
INFLATION
EFFICIENCY &
EQUITY
DR. MABID ALI AL-JARHI
7
WHY GOV’T BORROW FROM
CENTRAL BANK?
 It is politically easier than raising taxes.
 Less costly than borrowing from public.
 Financing politically unpopular actions.
 Easier to use for weak governments.
 Used by gov’ts with inefficient taxing
structure.
 The legislature does not have full control
on government internal borrowing.
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DR. MABID ALI AL-JARHI
8
THE ISLAMIC ECONOMIC
SYSTEM
THE BANKING STRUCTURE
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9
THE CENTRAL BANK
MANAGEMENT OF MONEY SUPPLY
 To provide for the transactions needs of the
community, especially in a growing economy.
 Set the money supply at the level, which
provides the “maximum” amount of
transactions services at a certain level of
income.
 Keep the level of prices stable.
 It is the real and not the nominal unit of money
that produces transactions services.

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DR. MABID ALI AL-JARHI
10
MONEY, GROWTH AND PRICES
Higher growth of money → excess demand
for goods (excess supply of money) at faster
rates.
 If markets to be sable, equilibrium will be
regained.
 The new level of inflation depends on price,
compared to quantity speeds of adjustments in
all markets, which can be related to:
 institutional framework of the economy,
 the degree of complementarities and
substitution between gooks,
 The rate of growth of the economy.

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DR. MABID ALI AL-JARHI
11
The rate of inflation (growth of
prices) can be written as

P
P ( p i ;i  1,..., n ) 1
Where (pi) is the rate of growth of the price of
the ith good, which is equal:
pi
dp i

/ pi
dt
p i ds i
 {
.
}/ p i
s i dt
where (si) is the excess demand for the ith
good:
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DR. MABID ALI AL-JARHI
2
12
Equation (2) decomposes the rate of growth
of the ith price into two factors
1. responsiveness of the price to changes in
excess demand, (price speed of adjustment).
2. the extent to which excess demand is
increasing or decreasing over time, (quantity
speed of adjustment).
 Speeds of adjustment can be hindered by non
competitive elements, e.g., monopolies.
 They also depend on the degrees of
substitutability and complementarities.
 the quantity speed of adjustment is faster with
higher rates of growth, as it becomes easier to
satisfy excess demands.
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DR. MABID ALI AL-JARHI
13
THE RELATIONSHIP BETWEEN
INFLATION RATE AND THE RATE OF
MONETARY EXPANSION
Ceteris paribus, the higher the rate of growth,
the lower the rate of inflation resulting from a
certain increase in the rate of monetary
expansion.
 The optimal supply of money is the rate of
monetary growth, which maximizes the
transactions services for the community.
 the optimal monetary policy is that which
brings monetary growth to the optimal level.

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The Relationship between the rate of
growth of the money supply and the rate of
growth of prices
The faster the growth of money, the stronger is
its effect on the real sector in terms of raising
demand schedules and, consequently, the
faster prices must rise.
 We can therefore perceive of rates of
monetary expansion low enough not to
produce any inflation, given the real growth of
the economy and the state of expectations

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DR. MABID ALI AL-JARHI
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FIGURE (1): THE RELATIONSHIP
BETWEEN INFLATION RATE AND THE
RATE OF MONETARY EXPANSION

P

O
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E
A
DR. MABID ALI AL-JARHI
M
16
FIGURE (2): ECONOMIC GROWTH
ATTENUATES THE EFFECTS OF MONETARY
EXPANSION ON PRICES

P
L1(g1)
L2(g2)
L3(g3)
L4(g4)

O6 June 2004 E2
E3
DR. MABID ALI AL-JARHI
E4
17
M
VARIATIONS IN MONEY SUPPLY
CENTRAL DEPOSITS, CD'S
 The central bank opens investment
accounts in its member banks.
 It deposits the money it creates and which
withdraws the money it retires.
 Banks will invest central deposits in the
real sector in accordance with the
investment policy of each.
 Profits earned would be used to cover the
cost of central bank operations.
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18
The central bank issues “central deposit
certificates",
 CDC's would be sold to the public and their
proceeds be invested in CD's throughout the
banking system,
 CDC’s would provide the lowest degree of
financial risk in an interest-free economy,
since each carries with it a title to a more
diversified investment portfolio than any
member bank by itself can provide.


The rate of return on the CDC's will
approach the average rate of profit on
investment for the whole economy.
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DR. MABID ALI AL-JARHI
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THE PROCESS OF MONEY CREATION
IN AN ISLAMIC ECONOMY
 It is a non-lending based process of monetary
expansion has several advantages.
 An investment-based process.
 CD’s rate of return gauges monetary policy
performance.
 Totally independent of government budget:
 Monetary policy would be depoliticized.
 The monetary authority will depend solely on
monitoring the relationship between prices and
output in deciding upon the (optimal) rate of
monetary expansion.
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DR. MABID ALI AL-JARHI
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THE OPTIMAL PATH OF MONETARY
EXPANSION
 Assume the central bank targets absolute price
stability.
 It will face a frontier of rates of growth, each
associated with a maximum rate of monetary
expansion that can be implemented without
increasing prices.
 We can term that rate the optimal rate of
monetary expansion or the optimal supply of
money.
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21
This frontier, the curve in figure (3), can be
termed the optimal path of monetary
expansion or the optimal path of monetary
policy.
 As the rate of growth increases, the maximum
rate of monetary expansion rises up to a limit,
after which no further increase in the rate of
monetary expansion without increasing the
rate of inflation.

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FIGURE (3) : THE OPTIMAL
PATH OF MONETARY
EXPANSION
e3
e2
e1
g1 g2
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g3
DR. MABID ALI AL-JARHI
g
23
THE OPTIMAL PATH
When the rate of growth is g1, the optimal rate
of monetary expansion is e1.
 when growth rises to g2, the optimal rate of
monetary expansion rises to e2.
 when the rate of growth is g3, the optimal rate
of monetary expansion is e3.
 e3 is the highest possible rate of optimal
monetary expansion.
 . Any further rise in growth will not be
associated with higher rates of monetary
expansion above e3.

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DR. MABID ALI AL-JARHI
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EXTERNAL INFLUENCES AND
THE MONEY SUPPLY
Foreign exchange holders use part to cover
purchases abroad, sell the rest to other residents,
and the banking system for domestic currency.
 The change in net foreign assets held by the
banking system will have a direct effect on
monetary expansion.
 This could distort the optimal supply of money
rule. Options faced by central bank:
 Neutralize all changes in net foreign assets by
absorbing resulting increase in the money supply.
 Inject an amount equivalent to any decrease in
money
supply resulting
from a decline in net 25
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DR. MABID ALI AL-JARHI
foreign assets.

Net purchases of foreign exchange by the central
bank can be invested through member banks.
 Both absorption and injection would be carried
out through the sale and purchase of CDC’s.
 Neutralize only the changes in the money supply
that would cause the path of monetary expansion
to deviate from its optimal path.
 Monetary authority can stand ready to sell and
purchase foreign exchange at daily declared
prices.
 Exchange rates would be set at levels that would
enable the monetary authority to keep the level of
net foreign assets consistent with the optimal
path of monetary expansion.

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EXTERNAL INFLUENCES AND
THE MONEY SUPPLY
The central bank can therefore keep
CD's in foreign currencies with
member banks for this purpose.
 It can issue CDC's denominated in
foreign currencies or domestic
currency equivalents.
 The proceeds of selling those CDC's
can be used to finance foreign
currency purchases.

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BANKS & FRACTIONAL RESERVES
Banks must undertake direct investment, take
equity in the firms they finance and provide the
rest of customary banking services as well.
 They take demand deposits.
 With fractional reserves, when traders switch
from “currency" to "deposit money" and vice
versa, the total supply of money will change.
 with one hundred percent reserves, such a switch
will change the composition of money, leaving its
total supply constant:
 Fractional reserves caused the monetary system
to suffer from an "inherent instability",

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In a fractional reserve system, the process
of creating derivative deposits is
accompanied by changes in the money
supply resulting from substituting deposits
and cash for each other.
 Both processes change the cost of producing
real balances.
 Such changes in the money supply make it
more costly to maintain the existing stock of
real balances or to add to it.
 The inherent instability and the cost of
producing real balances to warrant the
adoption of 100 percent reserves:

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FRACTIONAL RESERVES & EQUITY
Money, as a medium of exchange is the
creation of the whole society.
 Fractional reserves give banks’
shareholders a monopoly right to issue
money and profit at the expense of society.
 When fractional reserves are abolished, the
central bank gains the full value of
seigniorage and can use it for social benefit.
 In an Islamic economy, there is no
justification to redistribute wealth for the
benefit of banks’ shareholders..

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DIRECT INVESTMENT
(MUSHARAKAH)
 Establish new firms, wholly or partially
owned by bank.
 Hold shares in existing firms.
 Banks participates in management &
influences corporate governance.
 Provide technical assistance to correct
business decisions and to solve
problems.
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Banks benefit from:
 Geographic proximity to firms.
 , possession of first hand information
about their activities.
 relative familiarity with people
operating .
 Benefit from low cost of screening and
monitoring.

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PROFIT-AND-LOSS SHARING
FINANCE
Banks hold equity in firms, monitor their
operations cheaply and assess their needs, which
can be provided on a profit-and-loss-sharing
(PLS) basis.
 Short-term funds to finance business needs for
working capital for the duration of the
production cycle.
 The earnings of firms financed by banks would
be netted out of costs, and the remainder is
shared with banks according to an agreed upon
formula.
 The time length varies from six to twelve months
for
industrial and DR.
agricultural
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MABID ALI AL-JARHI projects, and as33
short as 60 or 90 days for commercial ventures.

LEASING ACTIVITIES
Banks purchase means of transport (ships,
planes, etc.), industrial equipment,
buildings, and others to lease them to users
in return for periodical installments.
 The lease agreement may terminate with a
title transfer to the user.
 A means to serve customers in a way that is
flexible enough to cater for varying need.
 A way to invest in an equity, which
transfers itself into liquid cash gradually
over a certain period of time.

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CREDIT-PURCHASE OR
COMMODITY FINANCE
Several formulas can be used to provide
commodities for spot delivery and deferred
payment. That includes bai’ mu'ajjal,
murabahah.
 Alternatively, producers can be provided
spot cash in return for future delivery of
goods, using forms of salam and istisna’.
 Some of these modes may require banks to
get involved in trade.

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ACTING AS HOLDING COMPANY
Banks take interest in firms and finance
their operations.
 banks can establish specialized subsidiaries
to handle their PLS, leasing and credit
purchase finance.
 Banks need only to hold part of the equity
of their own subsidiaries and attract the
rest from other shareholders.
 This keeps a reasonable amount of division
of labor in the banking industry, for the
sake of economic efficiency.

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NEED FOR LENDING ACTIVITIES
borrowing by business enterprises
would become unnecessary.
 some borrowing may still be needed.
 when individuals face emergency
situations or special needs that would
require short-term bridge financing.
 A modest amount of interest-free
lending must be provided as a
philanthropic activity.

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HOW TO PROVIDE LENDING
bank would be instructed to devote a small
percentage of its resources for interest-free
lending.
 The central bank can supplement such resources
from its CD earnings.
 Some would make funds available for interest
free lending for religious reasons, encouraged by
stable prices.
 Central bank can issue central lending
certificates, CLC's, which carry no return, but
are guaranteed to be paid on maturity.
 Proceeds of CLC's can be used by banks, to lend
the
needy after proper
assessment using social38
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DR. MABID ALI AL-JARHI
criteria, as rationing would be required.

CENTRAL BANK BALANCE SHEET
ASSETS
LIABILITIES
Cash in Vault
Central Deposit Certificates
Central deposits with banks,
restricted and unrestricted
Central Lending Certificates
Lending Accounts with Member
Banks
Member Bank Reserves
Investment Accounts for
Government and Public
corporations
Net Foreign Assets
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Monetary Base = Money in
DR. MABID ALI AL-JARHI
Circulation
39
ASSETS
LIABILITIES
Cash in Vault
Reserves with Central Bank
Demand Deposits
Equity In Subsidiaries
Central Deposits, Restricted And
Unrestricted
Unrestricted investment deposits
Accounts With Fund Users:
PLS Accounts
Leasing Accounts
Credit-Purchase Accounts
Restricted investment deposits
Mode-restricted deposits
Project-specific deposits
Sector-specific deposits
Assets owned by special funds and
portfolios
Unrestricted Investment Deposit
Certificates
Net Foreign Assets
Restricted Investment Deposit
Certificates:
Lending Accounts
Fund Shares
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DR. MABID ALI AL-JARHI
Central Lending Funds
40
THE TREASURY: AN ISLAMIC
PERSPECTIVE
THE DISTRIBUTIVE BRANCH: A distributive
tax, called Al-Zakah is levied on the following:
 Monetary asset holdings for one year, including
cash, demand deposits and debt, when held for a
year.
 Titles to real assets held for a year, e.g., shares,
profit sharing funds, etc, when held for a year..
 Gold, precious metals, and diamonds, on the
basis of their current market value, when held
for a year.
 Net earnings of assets not included in the above
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41
categories.

The tax rates, which differ from one category of
assets to another, are applied on total holdings
over and above a certain level, called nissab that
reflects the cost of living of the tax-payer.
 The proceeds are earmarked for certain purposes
on the top of which poverty reduction.
 This is done through two kinds of redistributive
policies: wealth maintenance and income
maintenance policies..
 Those whose income (and wealth) is below a
certain "minimum" level, are classified into two
categories, those capable and those incapable of
work.

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Those capable of work are given sufficient
productive assets to use in order to earn
income that would place them outside the
poor.
 the process of redistribution continues
every year and poverty is reduced gradually
and eventually eliminated in the long-run
for all capable of working.
 Banks would play a role, as wealth
maintenance policies can be implemented
through the finance of micro enterprises,
which the poor own and manage.

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THE ALLOCATIVE BRANCH
DIVISION OF MINERAL RESOURCES:
 The mineral Resource Division assumes the
responsibility of mineral production, directly or
indirectly, the proceeds of which are added to the
Treasury to be used in financing government
operations.
 The state ownership of mineral resources does
not necessarily imply state production.
 The state can involve itself in the production of
minerals through state owned enterprises .
 although it would be more efficient to enfranchise
private producers for this purpose.
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DIVISION OF PUBLIC GOODS:
 Public goods: goods which are consumed
collectively, e.g., defense, basic education and
certain categories of health services.
 Conditions of their provision are determined
through the political process, the state stands
responsible for providing them to its citizens.
 They may be produced directly by government
owned enterprises or, more efficiently, by private
sector enterprises.
 They are financed by the net proceeds from the
mineral resource division and from other taxes.
 Some of the public goods, like defense, can be
financed from Al Zakah proceeds given enough
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AL-JARHI
45
funds
after
satisfying the poor
DIVISION OF MARKET ORDER:
 The working of free markets can always be
disturbed by the rise of monopolies, the existence
of externalities, and other market "disorders".
 Dealing with such problems could involve a
certain tax subsidy network or direct regulations
by the government.
 In extreme cases, direct control may be called
for.
 The finance of such operations could be
accomplished through balancing tax services with
subsidy payments.
 It may also call for special taxes to finance the
maintenance of "orderly markets“.
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INSTRUMENTS
ISSUERS
STOCKS
ENTERPRISES
INVESTMENT CERT.
REST, UNREST
INVESTMENT
COMPANIES
DEPOSIT CERT
MUSHARAKAH CERT
LEASING CERT
FUND CERT
PORTFOLIO CERT
LOAN CERT
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DR. MABID ALI AL-JARHI
BANKS
CENTRAL
BANK
TREASURY
47
INTEREST RATE & PRODUCTIVITY
EXPECTATIONS IN A
CONVENTIONAL ECONOMY
The opportunity cost is the rate of
"return" on the safest and most liquid
financial asset, viz., government securities.
 In a lending centered economy, economic
agents tend to associate changes in the price
level with monetary growth.
 monetary expansion or contraction is
influenced, in the first instance, by the
desired level of government expenditures.
 This has consequences on the prices
expectations.

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When the government expands the money
supply by selling securities to the central
bank, the latter can attempt to offset such a
move by selling securities back to the
public.
 Even with a fairly wide market, such action
will raise the monetary rate of interest.
 The cost of money would rise, and
economic activities would be restrained in
the private sector while expanding in the
public sector.


The rate of interest would therefore
become a chariot of price expectations.
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When the central bank is capable of offsetting
the government monetary expansion, interest
rate could rise by a magnitude that is sufficient
to discourage any inflationary expectations.
 Although total offsetting is hardly conceivable,
it could lead to the contraction of the private
sector and an expansion of the government
sector.
 People compare the rate of monetary expansion
with the rise in the rate of inflation. An excess
of the former over the latter justifies
expectations of further inflation, until both are
equalized.
 Therefore, in lending centered economies price
expectations compare the rate of monetary
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50
expansion
with changes
in the rate of inflation.

The familiar equalization of opportunity
cost of money and the rate of return on
investment, at the margin, is only
illusionary.
 Savings are channeled through the banking
system on the basis of interest rate
expectations.
 Meanwhile, the production sector absorbs
those savings on the basis of productivity
expectations.
 When the saving process is lending
centered, interest rate expectations
dominate productivity expectations;
 This is a case of a tail wagging its dog!!

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PRICE EXPECTATIONS IN AN
ISLAMIC ECONOMY
Money is issued and allocated to uses on
bases related to growth and productivity
and far removed from political pressures
connected with public sector requirements.
 Lending plays an insignificant role.
 Cash and CLC’s, and other monetary assets
have a negative yield, after payment of
zakah.
 Holding CDC’s is next best alternative to
holding cash. They have the highest degree
of safety, and the lowest degree of risk for
income-earning financial assets.

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CDC's with short term maturities should be
encashable with a notice that is shorter than
other income-earning assets.
 CDC’s are allocated to banks according to
efficiency criteria. Their rate of return
approximates the average rate of return on
investment for opportunities lying on the
production frontier of the whole economy.
 CDC’s rate of return becomes in itself the
opportunity cost of money and the benchmark
for all uses of money.
 The proceeds of central deposit certificates are
invested in productive uses, this makes the
interest-free economy an investment centered
economy.

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Investors consider the safest possible
investment opportunity They do not
consider the safest possible lending
opportunity at all.
 Money holdings are considered in
comparison with investment opportunities
directly and not through a scheme of
financial intermediation based on lending.
 In this way, money and investment markets
are effectively interconnected.
 In contrast to the conventional economy,
the real sector dominates the financial
sector.
 The dog here can wag its own tail!!!

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54
THE DEMAND FOR MONEY IN A
CONVENTIONAL ECONOMY
The study of the demand for money in a
conventional economy starts with distinguishing
between transactions, precautionary and
speculative demand for money.
 Ultimately, all three kinds of demand are added
together in one aggregate called the demand for
money .
 Whether treating this demand was done through
the inventory approach (Baumol, 1952) or the
portfolio approach (Tobin. 1958), all analysts
agree that the quantity demanded for money is
inversely related to the rate of interest.

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One of the pillars of monetary analysis under the
conventional monetary structure is what is called
“inelastic expectations”.
 Agents believe in the existence of a natural rate of
interest that reflects economic fundamentals.
 When the rate of interest rises above or declines
below the natural rate, agents believe that it will
return back to its original level.
 When the rate of interest rises, bond prices
decline..
 Since agents expect the rate of interest to decline
in the future and consequently bond prices to
rise, they find an opportunity to make profit.
Speculators switch from cash balances to bonds.

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When the rate of interest rises, they switch from
bonds to cash balances.
 Therefore, the quantity of money demanded
increases when the rate of interest declines and
vise versa.
 This analysis represents the theoretical basis for
the downward sloping liquidity preference curve.
 Therefore people in the conventional system hold
money for speculative purposes either when they
expect prices to decline or the rate of interest to
increase.
 Expectations of lower future prices or higher
interest rates will both lead to a shift from real
and financial assets into money, thereby causing
a6 June
decrease
in
real
asset
and
bond
prices,
which
is
2004
DR. MABID ALI AL-JARHI
57
equivalent to an increase in the rate of interest.

THE DEMAND FOR MONEY IN AN
INTEREST-FREE ECONOMY
 The rate of return on CDC’s, or
RCDC, plays a central role in the
demand for money; it works as:
 A benchmark for investment.
 A rate of discount for future income
streams expected to accrue on financial
and real assets.
 A tool and an indicator for feasibility
studies and business planning.
 A market price for resource allocation.
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DR. MABID ALI AL-JARHI
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The demand for money must be directly
related to the RCDC.
 When that rate rises, agents will find that
they must economize on the use of
monetary resources in transactions and
switch some cash balances to investment.
 When it declines, agents will find that
holding money has become less costly,
thereby encouraging them to increase their
money holdings.
 A tool and an indicator for feasibility
studies and business planning.
 Therefore, the quantity demanded is
inversely related to the RCDC.

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DR. MABID ALI AL-JARHI
59
SPECULATIVE DEMAND FOR
MONEY
Expectations of higher RCDC's would
automatically be translated by the market
into higher prices of investment
instruments.
 When RCDC is expected to be higher, the
expected returns of other 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 of investment
instruments will always be higher than the
rise in the CDC rate.

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DR. MABID ALI AL-JARHI
60
The final conclusion is that expectations of
higher RCDC will not lead to a decline but
a rise in the prices of investment
instruments.
 Therefore, the quantity demanded is
inversely related to the RCDC.
 Similarly, an expected decline in the RCDC
must be associated with an expected decline
in the prices of investment instruments.
 However, expectations of such decline in the
rates of return on financial instruments will
not lead to a rise in speculative demand for
money unless the expected rates of return
fall below -2.5 percent.

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DR. MABID ALI AL-JARHI
61
In an interest free economy, prices should
be stable, since monetary growth is tied to
the rate of change in prices.
 if prices were expected to decline, because
e.g., some policy error, people would revert
to money, if the decline exceeds 2.5 percent.
 the effects of a rise in speculative demand
for money can be easily reversed through
monetary policy. This is more assured since
all monetary growth is automatically
translated in CD’s, which flow through
member banks to investors.

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DR. MABID ALI AL-JARHI
62
THE SAVING INVESTMENT
FUNCTION
Savings (S) is a function of the average rate
of return on investment () as well as on the
level of real national income (Y).
 Private investment () is a function of the
average rate of return on investment as well
as the level of real national income (Y).
 Public investment in the exploitation of
mineral resources, is included in private
investment, as it is decided upon in light of
profitability and national income.

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DR. MABID ALI AL-JARHI
63
THE SAVING INVESTMENT
FUNCTION
The rest of public investment is made by
monetary authority through the issue of new
money, i.e., through monetary expansion.
 The rate of monetary expansion depends on the
difference between the target and the expected
rate of inflation (π*-πe).
 Under absolute price stability when the target
inflation (π*) is equal to zero, rate of monetary
expansion will not increase unless the current
6 June 2004
DR. MABID ALI AL-JARHI
64
level
would lead the
economy to deflation.

THE SAVING-INVESTMENT
MARKET
 S (  ,Y )
S
I

 I (  ,Y )  I [Y ,(   )]
h
6 June 2004
g
DR. MABID ALI AL-JARHI
e
g
65
Conditions for public investment
through monetary expansion
I
g
I
g
I
g
6 June 2004
 0 if

(   )

e
g
0 if
(  )
0 if
(  )

DR. MABID ALI AL-JARHI
e
g
e
g
66
SAVING-INVESTMENT
EQUILIBRIUM FRONTIER
A rise in () would increase both
savings and investment, as investment.
Consequently income would increase
 The equilibrium frontier of the savinginvestment market can be represented
by a positively sloped curve that rises
between income and the rate of return
on CDC’s, similar to the Keynesian IS.

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DR. MABID ALI AL-JARHI
67
SAVING-INVESTMENT
EQUILIBRIUM FRONTIER

S ( ,Y )  I (  ,Y )  I [Y ,(   h )]
h
g
e

Y ,I, S
6 June 2004
DR. MABID ALI AL-JARHI
68
DEMAND & SUPPLY OF MONEY
M
M
d
s
6 June 2004


M (  ,Y ,  )
d
e
h

I [Y ,(   )]
g
DR. MABID ALI AL-JARHI
e
g
69
THE MONETARY EQUILIBRIUM
FRONTIER
Rising () means the real sector is performing
better and aggregate supply is rising. The
expected rate of inflation goes down and the gap
between target and expected inflation widens.
 It becomes safe to increase monetary growth
without violating inflation target. Central
deposits and ultimately investment increase .
 The equilibrium frontier of the money sector can
be represented by a positive relationship between
real income and RCDC.
 It would be parallel to the Keynesian LM curve,
but with a positive slope, as all money issued is
6 June 2004
DR. MABID ALI in
AL-JARHI
automatically
is invested
the real sector. 70

MONETARY EQUILIBRIUM


I (Y ,(   )  I [Y ,(   )]
g
e
g
e

Y ,I, S
6 June 2004
DR. MABID ALI AL-JARHI
71
FIGURE (4): FULL EMPLOYMENT
EQUILIBRIUM
FE
IS

LM
Y, I, S
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DR. MABID ALI AL-JARHI
72
the IS frontier is more elastic than the LM
frontier.
 Along the IS frontier, increases in RCDC
leads to higher savings and investment then
to higher income.
 income is more responsive to increases in
investment below the level of full
employment aggregate supply.
 it becomes relatively inelastic beyond the
level of full employment.
 The same applies to the LM curve but to a
lesser extent.

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DR. MABID ALI AL-JARHI
73
Higher RCDC’s () motivate the monetary
authority to issue more money and increase
central deposits, the expected inflation rate gets
closer to the target inflation rate, inhibiting
further increases in monetary expansion.
 Responsiveness of income along the LM curve is
therefore constrained by both the rate of inflation
and the full employment level of aggregate
supply.
 That is why the LM should be less elastic
everywhere than the IS curve.
 the elasticity of the IS relative to the LM frontier
appears from Figure (3) to be an equilibrium
condition.
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DR. MABID ALI AL-JARHI
74

MONETARY POLICY
The monetary authority can change money
supply through two means:
 The addition or withdrawal of cash to
central deposits.
 The sale and purchase of central deposit
certificates through open market
operations.
 Expansion must always be justified by a
possible contribution to real balances.
 central bank monitors real growth through
the investment performance of banks.

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DR. MABID ALI AL-JARHI
75
Growth and past price performance will provide
the central bank with information on whether a
faster expansion of the money supply can
contribute to real balances.
 Monetary policy could be viewed as closely
intertwined with development policy.
 the government may wish to encourage
investment in certain regions or sectors.
 This would conflict with the central bank
efficiency criteria used to allocate new money
among banks.
 It would introduce serious inefficiencies. It is
best that the monetary authorities’ concentrate
6 June 2004
DR. MABID ALI
AL-JARHI
76
on
stabilization rather
than
development.

TRANSFORMATION TO ISLAMIC
FINANCE
Moving from conventional to Islamic
finance cannot be done instantly or
overnight.
 It must be done gradually with
conscious planning and preparation .

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DR. MABID ALI AL-JARHI
77
THE CENTRAL BANK.
 Restructuring domestic and foreign assets
and liabilities on a non-interest basis.
 Liquidation of government and public
sector debt. The new resources, especially
from higher central bank profits, which
would include larger seigniorage, could be
used to repay the public debt. Some of the
debt can be swapped against equity in
public enterprises.
 Changing government and public sector
deposits to profit-and-loss-sharing deposits.
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DR. MABID ALI AL-JARHI
78
RESERVE REQUIREMENTS.
 Gradual transformation into 100
percent reserve requirements would be
advisable, since sudden switch would
create real hardships for banks.
 Increases in the required reserve ratio
should be accompanied by injection of
additional resources to banks through
central deposits.
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DR. MABID ALI AL-JARHI
79
TAX REFORM
 Al-Zakah plays a central role in the
interest-free financial system. In addition,
direct taxes are more consistent with equity
than indirect taxes.
 A new system would be needed in which
wealth and income taxes are main features.
 overly high rates of taxation must be
avoided and those with wealth below the
minimum necessary to cover for basic needs
must be exempted.
 Such approach would minimize tax evasion.
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80
UNIVERSAL BANKING
 The banking system needs to switch from
commercial to universal banking.
 This requires retraining bankers into this
new type of business.
 Banking regulations must be changed to
allow for universal banking activities.
 Particularly, feasibility studies, investment
evaluation and follow-up, management of
holding companies and monitoring of
subsidiaries would all be some of the new
skills required by bankers.
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81