Issuing money
In the conventional monetary model, money is created in the form of credit balances to be lent to the treasury as well as banks. The treasury uses those balances to cover the deficit in government budget. Banks use the balances as reserves to cover their (interest-based) lending to the public.
Under the fractional reserve system, the neoclassicists claim that fractional reserves create a multiple of reserves initially issued by the central bank in the form of the monetary base. Banks allegedly issue multiple reserves in the form of derivative deposits through lending to the public. The maximum amount of money issued would be equal to the monetary base multiplied by the money multiplier, which would be equal to the reciprocal of the required reserve ratio.
Some theorists, however, argue that banks do not wait for the central banks to issue the monetary base. They instead take the initiative to make loans and create derivative deposits, then rush to the central bank to cover their reserve positions. The central bank finds itself, at least in the short run, forced to oblige (Basil Moore, 2001). This opinion later found convincing empirical support (Kydland and Prescott, 1990). This means that the concept of the money multiplier has been a myth, with no factual support. At any rate, money in a conventional economy is issued on a lending basis. What then is the basis for issuing money in an Islamic economic system?
Before we answer this question, it is important to note that the misunderstanding regarding the money multiplier has led to theories that assume the exogeneity of money, which ends up claiming that money is only a veil, as changes in its rate of growth would only affect prices, leaving real variables unchanged.
In addition, the application of fractional reserves has weakened the grip of the central bank on the money supply, as most of the money supply would be issued by banks as multiple of the monetary base. It also allowed banks to gain wealth at the expense of the public as they lend money to the public at a rate of interest, while the public is the only party that can be credited with giving the quality of moneyness to money, through bestowing on it their general acceptance. Moreover, the use of the required reserve ratio as a tool of monetary policy appears to be counterproductive, as any change in the ratio would produce multiple changes in the money supply, threatening to make monetary policy a source of instability.
Based on these three reasons, Al-Jarhi’s model (Al-Jarhi, 1981, 1983) insists on the application of total reserves in order to provide the central bank with absolute power to control the money supply, to prevent the wealth redistribution in favour of banks’ shareholders, and to do away with a tool of monetary policy that mostly led to instability.
In Al-Jarhi’s model, money is created as credit balances to be credited to the central bank investment accounts with banks under the name of central bank deposits or central deposits, CDs for short. They are placed in Islamic banks based on the Mudaraba contract. The newly issued money would be allocated to Islamic banks according to their record of profitability and safety. Issuing and retiring new money by adding or subtracting from CDs would be the first and utmost tool to manage the money supply
In order to assist in managing and fine-tuning the rate of monetary expansion, the central bank issues monetary instruments called central deposit certificates, CDCs, which would be offered to banks, financial institutions, and the public. Their proceeds are added to CDs and allocated among banks in a similar fashion.
The CDCs represent an undivided common share in the Mudaraba pool of assets created by banks through their financing provided to the household and business sectors, using Islamic finance products. Such products are based on Islamic finance contracts that range from partnership in product, partnership in profit, investment agency, and Ijarah, as well as sale finance that includes deferred-payment sale and deferred delivery sale.
The CDCs stand to compete with other investments, like shares, fund certificates and sukuk. However, it is distinguished by being the lowest-risk monetary asset, thanks to the automatic diversification by the central bank, who knows the most about its member banks.3 Therefore, on the liquidity scale, it stands as the nearest asset to money in liquidity, while it pays a rate of return that is equal to the average of returns on all assets included in the Mudaraba pools of all banks in the economy.4
Estimating the real rate of growth: why?
We start with a relatively stable state of (disequilibrium) prices, where pressures of excess demands or supplies are in state of moderation, that is, with moderate pressure on prices towards upward and downward movements to their nearest disequilibrium values. Meanwhile, markets would be characterized with a degree of monopolistic competition, where markets are generally fragmented by brand names, geographic locations, and related price-searching tactics on the sides of both buyers and sellers.
Prices in such an environment vary with the degree of price differentiation related to promotion and advertisement activities and the related services provided by sellers. Traders, meanwhile, stay busy with price searching in a way that makes it impossible for any market to reach a stable equilibrium, due to the interactions (emerging or strategic behaviour) between traders in addition to information-cost differential between markets. This, we argue, is the realistic state that is far removed from the neoclassical attachment to stable equilibria, which increasingly appears as a fanciful idea.
In this disequilibrium mode, the movement towards or away from equilibrium would become vigorous or weaker depending on the extent of excess demands and supplies in markets and the degree of awareness among traders with these excesses as well as their expectations with regard to their effects. Some would expect price increases and therefore continue buying. Some others would expect price declines and therefore go for selling. In such an environment of uncertainty, expectations are mostly disappointed. Prices would thus continue to approach or go further from equilibrium, which continues to give rise to traders’ interaction or emergent behaviour.
In this economy, a higher rate of monetary expansion is followed by excess demands for all commodities to varying degrees. This leads firms to seek financing in order to provide more supplies. The fact that banks, using Islamic modes of finance without resorting to ruses, provide finance either to suppliers alone or demanders and suppliers together would closely connect the finance sector with the real sector, which are mostly disconnected in a market economy. It would attenuate price rises and allow the finance sector to positively influence the speed of adjustments in commodity markets.
Excess supplies would tend to go down, depending on the extent of monetary expansion and the responsiveness of supply to an increased availability of financing. What stands between the economy and equilibrium is the state of uncertainty, which caused producers to raise their supplied by an amount that is always significantly or slightly below or above what is needed to reach equilibrium.
Let us remember that we have started with an economy in disequilibrium, and then the emergent behaviour got hotter with the increase in monetary expansion. Because of the initial and following conditions, the relationship between monetary expansion and price stability remains central. To the extent that monetary expansion remains within the limits of economic growth, excess supplies dominate the scene, keeping disequilibrium prices calm. Once monetary expansion exceeds the limits of economic growth, excess demands dominate, forcing prices out of control. Therefore, the monetary authority must monitor the relationship between monetary expansion and economic growth for the benefit of reaching price stability.
If the increase in monetary expansion is far below economic growth, excess demand would be modest, and so would their effect on the speeds of adjustment and price levels. The opposite is also true. If the increase in monetary expansion exceeds economic growth, excess demands would be proportionately higher and the increase in prices would be larger.
While we make no claims to a perfect or competitive asset market, we can nonetheless claim that there would be some reasonable degree of general awareness among investors regarding the trade-offs between different investments (stocks, sukuk, fund shares, investment deposits in different banks, and direct investment).
We would not, therefore, indulge in making assumptions parallel to those made by the “efficient market hypothesis”. Some of those assumptions can be mentioned here as examples. First, the collective expectations of stock market investors are accurate predictions of companies’ future prospects. Second, share prices fully reflect all information pertinent to the future prospects of traded companies. Third, changes in share prices are due to changes in information relevant to future prospects. Such assumptions would make all knowledgeable prophets out of investors an...