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Transcript
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 6 June 2004 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 6 June 2004 DR. MABID ALI AL-JARHI 5 FIAT MONEY CREATION NO LIMITATIONS ON MONEY SUPPLY RUNNING INFLATION 6 June 2004 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 6 June 2004 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. 6 June 2004 DR. MABID ALI AL-JARHI 8 THE ISLAMIC ECONOMIC SYSTEM THE BANKING STRUCTURE 6 June 2004 DR. MABID ALI AL-JARHI 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. 6 June 2004 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. 6 June 2004 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: 6 June 2004 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. 6 June 2004 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. 6 June 2004 DR. MABID ALI AL-JARHI 14 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 6 June 2004 DR. MABID ALI AL-JARHI 15 FIGURE (1): THE RELATIONSHIP BETWEEN INFLATION RATE AND THE RATE OF MONETARY EXPANSION P O 6 June 2004 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. 6 June 2004 DR. MABID ALI AL-JARHI 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. 6 June 2004 DR. MABID ALI AL-JARHI 19 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. 6 June 2004 DR. MABID ALI AL-JARHI 20 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. 6 June 2004 DR. MABID ALI AL-JARHI 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. 6 June 2004 DR. MABID ALI AL-JARHI 22 FIGURE (3) : THE OPTIMAL PATH OF MONETARY EXPANSION e3 e2 e1 g1 g2 6 June 2004 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. 6 June 2004 DR. MABID ALI AL-JARHI 24 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 6 June 2004 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. 6 June 2004 DR. MABID ALI AL-JARHI 26 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. 6 June 2004 DR. MABID ALI AL-JARHI 27 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", 6 June 2004 DR. MABID ALI AL-JARHI 28 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: 6 June 2004 DR. MABID ALI AL-JARHI 29 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.. 6 June 2004 DR. MABID ALI AL-JARHI 30 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. 6 June 2004 DR. MABID ALI AL-JARHI 31 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. 6 June 2004 DR. MABID ALI AL-JARHI 32 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 6 June 2004 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. 6 June 2004 DR. MABID ALI AL-JARHI 34 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. 6 June 2004 DR. MABID ALI AL-JARHI 35 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. 6 June 2004 DR. MABID ALI AL-JARHI 36 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. 6 June 2004 DR. MABID ALI AL-JARHI 37 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 6 June 2004 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 6 June 2004 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 6 June 2004 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 6 June 2004 DR. MABID ALI AL-JARHI 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. 6 June 2004 DR. MABID ALI AL-JARHI 42 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. 6 June 2004 DR. MABID ALI AL-JARHI 43 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. 6 June 2004 DR. MABID ALI AL-JARHI 44 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 6 June 2004 from that source DR. MABID ALI 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“. 6 June 2004 DR. MABID ALI AL-JARHI 46 INSTRUMENTS ISSUERS STOCKS ENTERPRISES INVESTMENT CERT. REST, UNREST INVESTMENT COMPANIES DEPOSIT CERT MUSHARAKAH CERT LEASING CERT FUND CERT PORTFOLIO CERT LOAN CERT 6 June 2004 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. 6 June 2004 DR. MABID ALI AL-JARHI 48 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. 6 June 2004 DR. MABID ALI AL-JARHI 49 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 6 June 2004 DR. MABID ALI AL-JARHI 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!! 6 June 2004 DR. MABID ALI AL-JARHI 51 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. 6 June 2004 DR. MABID ALI AL-JARHI 52 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. 6 June 2004 DR. MABID ALI AL-JARHI 53 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!!! 6 June 2004 DR. MABID ALI AL-JARHI 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. 6 June 2004 DR. MABID ALI AL-JARHI 55 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. 6 June 2004 DR. MABID ALI AL-JARHI 56 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. 6 June 2004 DR. MABID ALI AL-JARHI 58 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. 6 June 2004 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. 6 June 2004 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. 6 June 2004 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. 6 June 2004 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. 6 June 2004 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. 6 June 2004 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 6 June 2004 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. 6 June 2004 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. 6 June 2004 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. 6 June 2004 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 . 6 June 2004 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. 6 June 2004 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. 6 June 2004 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. 6 June 2004 DR. MABID ALI AL-JARHI 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. 6 June 2004 DR. MABID ALI AL-JARHI 81