1. INTRODUCTION

It is readily obvious that in the modern "capitalistic" economy system, the interest elements plays a very important role, and it is almost inconceivable that the system could function without the interest component. Interest has been viewed not only as an integral part of the price mechanism whereby savings and investments arc regulated in a "laissez faire" system but also as an important policy instrument with which government interventions can be made to influence and control the economy. The mechanics of monetary control through variations in the rates of interest are not our immediate concern. It is nevertheless pertinent to point out that-monetary policy is often equated with interest rate management of the central banks and is conceived as a macroeconomic weapon which will become blunt if the interest element is eliminated.

The main aim of the present paper is to scrutinize the above hypothesis that interest is an all-important macroeconomic variable in the formulation of an effective monetary policy in a "modern" economic set-up and to visualize the role of monetary policy in an interest-free Islamic economy.

2. THE ROLE OF INTEREST IN MONETARY ECONOMICS 

An operational definition of monetary policy is useful for the analysis of the role of interest rates. Monetary policy may be defined as and deliberate action undertaken by the monetary authority to alter the quantity, availability and cost (i.e., interest rate) of money. It then becomes clear that interest rate is only a part of the story, although interest rate changes apparently influence the demand for and the supply of money. But, it is also conceivable that changes in the quantity and availability of money can he brought about even without having to alter the interest rates. Be that as it may, monetary policy based on interest rate manipulations suffer from seriou shortcomings which have severe implications tor the efficacy of monetary policy. To analyse these issues systematically, we need to examine first the quantity theory of money. 

2. A  Quantity Theory of Money

Let us first invoke Fisher's famous equation of exchange. MV = PT where M is the total money stock. 'V' its velocity of circulation. 'T' the total volume of transactionsand and 'P' the general price level. This equation simply asserts that the total money expenditure equals the monetary value of all goods and services traded. This identity can, however, be transformed into a theory that a change in the quantity of money would affect the general price level by holding the velocity of money and the volume of transactions constant. To accommodate a situation of less than full employment, the equation may be rewritten as MV = PQ, where 'Q' represents output, so that changes in the money stock would affect the level of output.

The traditional version of the quantity theory of money was too mechanistic to be of any value to policy makers. It must, however, be noted that interest rate had no role to play in the traditional quantity theory, which had maintained that the only substitute for excess money balance was goods and services, virtually ignoring the financial assets.

By recognizing financial assets as a close substitute for money, Keynes initially conceded that changes in interest rate could influence the general price level, although quantity of money would still   remain the key variable. [1] Keynes subsequently reversed the relative importance of the stock of money and the rate of interest, the latter exerting a more direct impact upon the general price level through its influence on savings and investments, the former being relegated to an indirect role of influencing the interest rate. [2] Moreover, the possibility that interest rate may change on its own accord even without a corresponding change in the money stock meant that fluctuations in the price level were independent of changes in the money stock.

The final Keynesian assault on the quantity theory came with the special case of the "liquidity trap" which highlighted the circumstances in which an increase in the. money stock would have no influence whatsoever on the interest rate, leaving the economy virtually unaffected. [3] This possibility exists if the interest rate reaches such a low level that no further fall in the rate of interest, and hence no further rise is bond process, are anticipated, so that the increased money stock is merely absorbed into idle speculative balances. The velocity of an idle deposit being zero, an increase in money stock is completely neutrali/ed by a decrease in its velocity so that total monetary expenditures remain unchanged with no impact at all upon the economy.

Although Keynes seemed to have treated the "liquidity trap" case as no more than an interesting theoretical possibility, the Keynesian analysis lias cast serious doubts on the potency of monetary policy. With the demand for money being unstable and investment being generally insensitive to changes in interest rate, changes in money stock will have no predictable effects upon the national economy.

The modern quantity theory, associated with the Chicago school, postulates a stable demand function (i.e., a constant velocity of money in circulation) for real money holdings, the independent variable being subject'to only slow changes, whereas the stock of money can be varied almost at will. The implication is that changes in the value of money are rather supply-determined and that the demand for money is independent of its supply. In the modern theory, money is regarded as a close substitute tor all assets, real and financial, so that a change in the money stock would cause a general increase in the demand for goods in the commodity markets in addition to its immediate impact on the interest rate in the financial markets.

In the modern version of the quantity theory, demand for money is generally insensitive to changes in interest rate, which means that a given change in money stock is not offset by a countervailing change in the demand for money caused by a change in interest rate. [4] In other words, the demand for money is not sensitive enough to permit a change in money stock to exert a predictable impact upon expenditures. It is, thus, the volume of money rather than the interest rate which plays the crucial role in the modern reformulation of the quantity theory. And high interest rates would then indicate not necessarily a tight money situation but simply an inflationary situation where the lenders of capital demand higher rates of interest to safeguard their real incomes.

2B.  Policy implications of the Quantity Theory

Implicit in the quantity theory of money, especially in the revised modern version, is the powerful influence that monetary variables can exert not only on the nominal magnitudes but also on real output and employment. But there are reservations about the use of "active" monetary policy as a countercyclical device, owing to the uncertainty of the time lag between policy action and income response and the consequent dangers of destabilizing impacts. Nevertheless, the postulate that a change in the monetary variable can have predictable effects upon the economy clearly suggests that monetary policy is a viable macroeconornic device.

The Keynesian objections to the use of monetary policy stems mainly from the premrse that the volatility of velocity and the insensivity of investment to changes in interest rates render the monetary instrument some what impotent. Although the quantity theory assigns a more important role to the volume of money rather than to the rate of interest as a monetary variable in influencing the economy, it apparently concedes that interest rate is a significant instrument variable that could influence the economy by affecting the cost and the availabity of the loanable funds.

2C.  Cost of Credit

Interest constitutes a cost to the borrower and a return to the lender. It then follows that the banking sector could affect the level of investments and the flow of new savings by controlling the rate of interest via adjustments in the stock of money. Interest is then conceived as an important monetary variable. The effectiveness of monetary policy would, however, depend upon the sensitivity of investment and saving to changes in the rate of interest.

It cost-of-credit considerations are totally irrelevant tor investment decisions. interest rate variations will have no impact at all upon the economy. If cost-of-credit considerations are irrelevant within a certain range of interest rates, the usefulness of monetary policy is partially impaired. If credit-cost considerations matter in the upward direction only, monetary policy becomes asymmetrical in its impact. Indeed, these possibilities cannot be ruled out.

The Keynesian analysis unambiguously suggests that it is business expectations and not eost-of-credit considerations which strongly influence investment decisions. Relatively high interest rates may not deter the business community from undertaking new investment activities if business expectations are buoyant. High capital costs will then be passed on to the consumers in the form of higher product prices. Relatively low interest rates, on the other hand, may not stimulate new investment if the business outlook is extremely gloomy. It would then follow that a monetary policy based on interest rate manipulations cannot serve as an effective countercyclical device, especially in situations of extreme pessimism and optimism.

There is fairly reliable empirical evidence [5] to support the view that investment demand is generally insensitive to changes in the rate of interest. It even appears that cost of capital hardly enters into investment decisions.

That potential investors do overlook marginal changes in the rate of interest is not  necessarily inconsistent with the view that they would respond to significant changes in the rate of interest. Besides, capital-cost considerations may well become important beyond certain level of interest rate, so that even marginal changes in cost of credit are taken seriously into account by potential investors. In other words. interest rate has to be sufficiently high for monetary policy to be effective. But there are severe constraints upon the permissible level of interest rates, as will be shown shortly.

There are also limits below which interest rate may not sink, as typified by the Keynesian "liquidity trap". These limits are reached when bond prices have risen to such a level that further increases in bond prices are not anticipated. Under these circumstances, excess money balances, resulting from an expansionary monetary policy, would merely be held in idle deposits, especially since the opportunity cost of the doing so in term of forgone interest rate is small in view of the low rate of interest and since the risk of capital losses associated with bond purchases arc rather high.

2D.  The "Locking-in" Effect

The preceding discussion suggests that changes in the rate of interest may not significantly affect the demand for invcstible funds. Whilst modern monetary analysis seems to play down capital cost considcratins in investment demand, it also stresses the possibility that rising interest rates could dampen investment activities by stifling the supply of investible funds due to the "locking-in" effect. For increases in interest rates would depress bond prices thereby preventing the financial institutions from selling bonds to make liquid funds available for potential investors. In other words, high interest rates, even if they do not discourage investment demand, would effectively "lock-in" funds thereby curbing investment activities.

Thus the 'Locking-in" effect of a rise in the interest rate would render monetary policy effective, notwithstanding the Keynesian stance regarding the buyoancy of expectations as the major determinant of investment activities and the empirical observation regarding the interest-inelasticity of investment demand. If this is the case, monetary policy becomes decidely asymmetrical. Whilst a monetary policy that raises the rate of interest during a boom will prevent new investments by effectively "locking-in" funds, a monetary policy that reduces the rate of interest during a depression will not stimulate investment activities in the wake of pessimistic business expectations by merely "unlocking" loanable funds

The strength of the "locking-in" effect, and hence the efficacy of the monetary policy, will depend upon the the age-profile of government securities. The potential capital losses associated with high interest rates are greater in the case of longer-dated securities. But the potency of monetary policy in terms of the "locking-in" effect have been questioned even for longer-dated securities.

It was seen that financial institutions will be unwilling to sell securities so as to make funds available for investment if the interest rate rises, thus depressing security prices. The main deterrent here is the potential capital losses that financial institutions will suffer as a result of a fall in bond prices. However, if the potential investor, encouraged by buoyant business expectations, is willing to offer higher interest rates, thereby creating an interest differential which adequately compensates for the capital losses, a tight money policy that raises interest rates will fail to "lock-in" funds. In other words, the "locking-in" effect will not be a sufficiently strong deterrent to investment, if availability, and not cost of credit, is the essence of the investment decision. [6] This will be the case especially if the financier is interested only in net income yield and not the overall net worth of his financial assets.

Moreover, the "locking-in" effect will not work if an increase in the interest rate which depresses the bond prices leads to expectations that the interest rate will continue to rise, depressing bond prices further. Such "elastic" expectations provide an incentive for a financial institution to sell its securities so as to avoid bigger capital losses in the future, thereby releasing funds for investment.

Furthermore, a tight money situation created by increased interest rates may generate an inflow of funds into those financial institutions which raise their short-term deposit rates. Those financial institutions will then be able to lend more without having to release their security holdings. Thus funds will be made" available so long as the potential investors are willing to pay higher interest rates.

The forgoing considerations apparently weaken the theoretical appeal of the monetary policy that relies on increases in interest rates to "lock-in" investible funds. Even if the "locking-in" effect successfully arrests the availability of funds for investment, it may be offset by an increase in the efficiency with which the available money stock is being utilized, i.e., an increase in the velocity of money.

An increase in the rate of interest raises the opportunity cost of holding idle money balances so that firms and individuals will have an incentive to economise upon their transaction cash holdings while the speculative demand for money will also fall, now that bond-prices have fallen. This general decline in the demand for money enables a given stock of money to finance a larger volume of expenditures.

The commercial banking sector may respond to high interest rates offered by the would-be investors by selling their short-dated securities so as to make invcstible funds available. Deposits destroyed by the sale ot government securities are matched by new deposits ereated by granting ot new loans. But the new deposits so ereated are decidedly aetive whereas the old deposits destroyed by the purchase of securities are largely idle. [7] The restrictive monetary policy may thus lead to the conversion of idle into active deposits thereby generating an increase in the velocity of circulation.

Non-bank financial institutions may develop innovations to overcome monetary restraints imposed by the monetary authority. For example, non-bank financial intitutions. which are not subject to the same degree of credit control as the commercial banks, may effect a transfer of deposits from the commercial banks by creating an interest rate differential, now that the would-be investors offer high rates of interest to escape the credit squeeze. Since non-bank financial institutions normally maintain reserve ratios lower than the conventional commercial bank ratios, the net effect of the deposit transfers is to enable a given monetary base to finance a larger volume of expenditures.

In the final analysis, the effectiveness of the tight money policy depends upon the level of interest rate. The interest rate will have to be sufficiently high for the restrictive monetary policy to effectively curtail the availability of investiblc funds just as it has to be high enough for the potential investors not to ignore considerations of cost of credit in their investment decisions.

2E.  Constraints on Interest Rates

The preceding analysis has demonstrated that the interest rate must reach a rather high level in order that increases in the rate of interest affect investments either by curbing the investment demand or by curtailing the availability of investible funds. But as has been pointed out already, there are severe constraints upon the permissible level of interest rates.

First of all, implicit in the high level of interest rates is the heavy burden of National Debt. A higher rate of interest raises the costs of debt servicing, which implies a heavier tax burden and a more inequitable income distribution in favour of the creditors who are presumably the better-off members of society.

Second, a high level of interest rate tends to foster the development of the monopoly sector of the economy, which is in a better position to pass on the I increased costs of credit to consumers in the form of increased product prices and which has easier access to alternative means of finance than the competitive sector. [8] The danger here is that a restrictive monetary policy may have destabilizing consequences. High interest rate may add to inflationary pressures by raising the cost of productions which the monopoly sector will suecssluily transmit to the consumers in the form of higher product prices. Thus a demand-pull inflation may merely be transformed into a cost-push one. Besides, in a hyper-inflationary situation, rising interest rates may well be viewed simply as any other price increases and may be accommodated accordingly without any contractionary effect.

Finally, high rates of interest tend to favour short-term projects and discourage long-term ones, since the longer pay-off period renders the latter unattrative. [9] In other words, high rates of interest are not conducive tor enhanced economic growth. This seems to pose a conflict between the stabilization and growth objectives.

2F.  Policy Implications

A number of important policy inferences may be made from the above analysis with respect to the use of the interest rate variable in monetary management. First, interest rate is not a double-edged weapon in the sense that it does not cut both ways equally. It seems to be more potent as an anti-inflationary device than as an anti-deflationary instrument. Second, its potency even as an antideflationary device is not unquestionable, since there are fairlly strong theoretical and empirical bases which suggest that  increases in the rates of interest may neither dampen the investment demand nor curtail the availability of funds significantly. Of course, it is conceivable that interest rates may reach such a high level that the increase cost of funds can no longer be ignored by would-be investors, and the size of potential  capital losses can no longer be overlooked by the financial institutions whose main business is to make more funds available for investment. But, then, there are theoretical limits beyond which it is not desirable to let interest rates rise. 

All these considerations cast serious doubts on the wisdom of using the interest rate as a monetary policy instrument. This, however, does not necessarily imply that monetary policy has little or no scope in any economic system. After all. the interest rate is only one element in the monetary set-up. Indeed, modern monetarists argue that it is the stock of money, and not the rate of interest, which is crucially important from the macroeconomic policy viewpoint. The implication is that monetary policy can be activated without having to draw interest rate into the picture. This is a policy conclusion is of considerable relevance to an Islamic economy in which interest has no legitimate role to play.

It must, however, be stressed that merely on the basis of the above, analysis, the influence of interest rate on investment decisions in a capitalistic economy cannot be dismissed out of hand. Of course, the argument that interest rate is not all that effective as marcroeconomic policy tool does not necessarily deny the role of interest rate as an allocative agent in the microcconomic sence. Thus, tor example, a
situation of buoyant expectations, when a rise in the interest cost does not deter the potential investor, does not mean that the investor fails to equate interest rate with the marginal efficiency of investment. It may simply mean that bouyant expectations would cause the marginal efficiency schedule to shift outward so that investment will rise despite an increase in the interest rate.

The main purpose of the preceding analysis is to show that the interest element is not an indispensable macroeconomic policy instrument. To be sure, it is not at all necessary to demonstrate the shortcomings and inadequacies of the interest rate weapon in the capitalist system in order to vindicate Islam's stance on interest. Nonetheless, it serves to throw light on the instrument which needs to be discarded or replaced in an Islamic economy and helps to overcome the "psychological barrier" that interest rate is too important a cog to be removed.

3.

MONETARY ECONOMICS IN AN ISLAMIC SOCIETY

Islam prohibits the payment and receipt of interest. The Holy Qur'an and the Hadith have been unambiguous on the question of interest, although there have been discredited attempts to suggest that Islam is against excessive interest rates only and that reasonably low rate of interest is not inconsistent with the Islamic ideology The truth remains that Islam disapproves of the payment and receipt of interest regardless of what forms and magnitudes it may assume and the end uses to which the borrowed funds are applied.

Our objective in this section is not to substantiate the Islamic stance on the issue of interest with elaborate references to the Qur'anic and other sources, but to visualise a system which would enable monetary policy to play a useful role in an interest-free environment.

3 A.  Economic Rationale for Zero Interest Rate

It is well known that the interest element is given a respectable place in the capitalist system, although the theoretical explanations ot the interest phenomenon arc far from satisfactory. If interest is conceived of as a reward for saving, as the classical theory indeed asserts, why do people save at all if they do not intend to lend their savings at interest? Why must interest be charged on money not saved but inherited? These are not rhetorical questions. The classical theory treats saving as a function of interest and claims that a particular interest rate is required to bring about equality between saving and investment. Since the bulk of saving in a modern society is accounted for by corporate saving and the bulk of borrowing is financed not by individual savings but by credit created by commercial banks, interest cannot be simply a reward for saving, nor can saving be determined by the rate.of interest per se. It is interesting to note that Keynes regards saving as a function not of interest rate but of income. In an Islamic society, people save mainly because Islam urges its followers to practice thriftiness in spending and moderation in consumption. For frugal spending is equivalent to honest earning, according to al-Hadith.

Interest is sometimes perceived as a price paid for sacrifice involved in abstaining from present consumption, since people tend to value the present more than the future. However, it is also plausible that "sacrifice" incurred by abstinence varies inversely with income levels. Why, then, do the rich charge exhorbitant interest rates on their savings when their "sacrifice" in abstaining from present spending is rather negligible compared with the "sacrifice" by the poor who live hand-to-mouth? This obviously involves interpersonal comparisons which modern economists seek to avoid. The capitalist economic system cashes in on product differentiation, persuasive advertisements, built-in obsolescence, market innovations, etc.. all of which are largely aimed at the consumers who indulge in conspicuous consumption. In such a world of consumption "temptations", abstaining from present consumption or postponing it to a future date becomes a really difficult task. Seen in this light, interest as a reward for income that is not consumed would seem justifiable. But Islam strongly advises, its followers against conspicuous consumption and economic excess, and firmly advocates simplicity in consumption habits. In a society where a low posture in consumption is simply a way of life, the abstinence explanation of interest loses its theoretical appeal.

Interest is sometimes attributed to the productivity of capital. This neo-classical explanation of interest obviously begs the question of why interest must be charged on consumption goods. Even in the case of capital borrowings, the productivity of capital may turn out to be negative due to, say. unexpected excessive fall in product prices. Why, then, must interest be charged on such capital? The productivity theory cannot explain it. The Islamic stance is fairly straight-forward: capital by itself is not productive, and it is the application of human efforts to a stock of capital which generates output and income. The reward for capital, then, cannot be legitimately fixed in advance, unlike interest rates, but can only be determined in retrospect, depending on profits or losses.

The so-called modern explanations of interest emphasize the opportunity for making a gain with the use of borrowed funds as the basis for interest payments. The pertinent question then is: what about the possibility of incurring losses when borrowed funds are used? The Keynesian view that interest is the premium on current cash over deferred cash is based on the concept of liquidity preference, which appears to be a psychological phenomenon in which speculation plays a central role. But speculation itself is disfavoured in Islam, as it is often associated with hoarding and profiteering activities which are anti-social. Islam thus demolished the very psychological foundation of the institution of interest and asserts that the normal rate of interest is really the zero rate.

Islam enjoins its followers to strive for their living and not to live on the toils of others. The very spirit of Islam is against living by owning without working. Seen in this light, interest resembles unearned income.

In an Islamic society the individuals may save and invest but the distinction between saving and investment is somewhat blurred. Since saving and investment decisions are not completely independent but are, to a large extent, interdependent in an Islamic economy, the Keynesian divergence between saving and investment, and hence the major cause of cyclical fluctuations, docs not arise significantly. Of course, saving will not equal investment if a part of the saving is hoarded. And "hoarding" represents savings that are not transformed into investment. Hoarding is simply an act of holding money in idle reserves, and "lending" money out of this idle reserve therefore merits no monetary remuneration in the form of interest.

Islam does not tolerate economic waste and hoarding is therefore vehemently discouraged, while the Islamic fiscal device of Zakah in a sense penalises those who hoard. All these imply that the gap between saving and investment is minimized. To avoid waste of resources, saving must be put to productive uses either by investing one's own funds and facing the risks of profits and losses associated with it, or by allowing others to use the funds through "lending". "Lending" thus relieves the hoarder of the burden of sitting on idle money balances. There is thus no room for interest in an Islamic economic system.

We need to distinguish between profit and interest. Interest differs from profit especially in that its rate is "fixed" in advance at the time of transaction regardless of whatever happens to the venture, whereas the profit rate is knwon only in retrospect and may turn out to be positive, zero or negative. Profits are thus clearly associated with risks that investment entails. So long as the owners of investible funds are willing to share these risks, the returns they get are legitimate profits. Merc "lending" of one s iunds without assuming investment risks does not entitle an individual to any return. By not differentiating between capital ownerships and cntrepreneurshin Islam does not give rise to the emergence of financiers who live on interest earnings as distinct from entrepreneurs who thrive on assuming business risks.

3B.  Hoarding, Lending and Investment

Individuals or households with excess of income over consumption face the choice of hoarding it in the form of idle reserves or lending it to others who will be able to use it or invest it. All these alternatives have different economic implications from the earnings point of view.

Although "hoarding" implies holding money balances in idle deposits, it does not necessarily constitute an absolute waste of financial resources, since one may like to hold some liquid cash at any given time for, say, precautionary motives. The nominal returns on idle balances arc obviously zero while the real returns might be negative in a world of rising prices which reduce the value of money. Thus there are real costs involved in holding idle reserves.

Excess money balances (i.e., excess of what is normally held in idle reserves) may be cither invested if one is willing and able to bear risks or lent if one is not prepared to face risks. If the latter were the case, the choice is really between hoarding and lending. That Islam forbids interest earnings does not necessarily imply that the individual will be indifferent between hoarding and lending. For one thing, as was argued earlier, it is unethical in Islam to promote economic waste implicit in hoarding. Besides, and equally important, idle balances have real costs, mentioned earlier, which the individual can avoid by lending his funds if the funds so lent out are protected against the risk of erosion in the value of money.

It appears that a nominal rate of return equivalent to the actual rate of increases in general prices [10] is not necessarily inconsistent with the Islamic ruling on interest, on two counts: (a) a nomial return equivalent to the increase in general price indices merely means zero return in real terms and (b) this nominal return is determined only in retrospect and not "fixed" in advance, quite unlike interest rates. The practical difficulties of determining this nominal return based on price indexation may weaken the theoretical appeal of this prescription, but such difficulties can be largely overcome it "lendings" are institutionalised. "Lendings" may take the forms of interest-free "current" deposits which may be used to make interest-free advances for non-investment purposes, imposing, of course, service charges on borrowers.

It must, however, be conceded that such compensation to lenders based on indexation, even in the nominal sense, may not be compatible with Islamic jurisprudence. This appears to be basically a question of interpretation and opinions may differ. But, it seems that such compensation is already implicit in lending-borrowing transactions where debts are delineated in kind. Thus, for example, a ton of wheat borrowed and returned implies such compensation when the price of wheat rises during the lag. The borrower has the choice of either borrowing money to buy a ton of wheat or borrowing a ton of wheat itself. If the price of wheat rises during the lag, he would cither return more money than what was borrowed or acquire a ton of wheat at a higher cost - equal compensation is involved in either case. It is difficult to see how one can be considered legitimate while the other cannot. If it can be resolved that individual commodity indexation is permissible, it can be extended also to a bundle of commodities.

A seemingly serious objection to such compensation for financiers is that it would confliet with the concept of social justice in Islam, unless of course such compensation is also extended toothers, e.g., wage earners and rent recipients. But, such a policy will he simply inflationary and self-defeating. We should, however, guard ourselves against logical pitfalls here. We should hear in mind that the issue at hand is compensation tor the financier and not his income, for his income from lending" is zero in an interest-free Islamic system whereas wage earners and land owners receive positive remuneration. Therefore, the question of compensation for financiers in an Islamic economy need not he confused with that for other factors such as labour and land in an inflationary situation.

To say the least, the indexation proposal to offset the effect of inflation on "financiers" deserves careful scrutiny before it can be adopted within an Islamic-framework or dismissed out of hand.

Investments may be "direct" or "indirect". "Direct" investments represent total commitment of funds in one's own economic ventures (i.e., sole proprietorship or partnership) where the returns, i.e., profits, may be positive, zero or negative in real or nominal terms. "Indirect" investments imply funds being channelled through an institutional intermediary on a profit-sharing basis, and the returns - which are not predetermined - may again be positive, zero or negative. Saving and investment of this variety may be effected through an Islamic banking system which permits "time deposits" to be translated into equity shares along, say, cooperative lines so that the "depositors" become co-owners of the financial institution which in turn will commit these financial resources again on a profit-sharing basis, declaring dividends at the ,end of the year if profits arc made.

3C.  Demand for Money and Government Securities

In an Islamic economy the substitute for money is essentially goods and services as in the case of the Classical economic system. To put it differently, transactions demand for money consitutes the dominant motive for holding money. However, the precautionary motive in itself is not un-lslamic. Whether or not there is room for speculative motive as well, depends upon the line we draw between speculation and gambling. Should we define the former as one where existing risks are calculated and countered and the latter as one where new risks are created, speculative demand for money may well be legitimate within an Islamic framework. A word of caution, however, is in order. Speculation is frowned upon in Islam as it often entails stockpiling and profiteering activities which have adverse economic implications for the community at large.

According to the Tradition, for instance, the sin committed by hoarding.grains with the hope that prices will rise cannot be obliterated fully even if the entire stock is given away as charity. However, Imam Al-Ghazali makes a distinction between stock-piling in times of shortage and that in times of surplus, and suggests that the former is objectionable and the latter is not. In other words, Islam does not decry
specolation in general; it is against destabilizing speculation only. Even if we lend some legitimacy to the speculative motive within the Islamic framework, the role of interest-bearing bonds and the inverse relationship between bond prices and interest rates and its monetary implications in terms of speculative balances are all completely irrelevant in the Islamic context.

Government bonds need to be redesigned both as a source of deficit financing and as a means of monetary control. The profit-sharing principle cannot be evoked since a substantial proportion of these funds are used to meet recurrent and development expenditures which do not yield monetary returns and since private individuals cannot acquire equities in public enterprises which are government-owned Nevertheless, "lendings", characterized by their zero real return, may partake of the character of interest-free bonds. Individuals, however, may be reluctant to commit their funds for any specific period of time in government bonds and may prefer to deposit such excess money balances in the form of interest-free "current" accounts which can be withdrawn at a very short notice. This means that government bonds can be sold mainly to financial institutions. Insofar as individuals are concerned.it will amount to "indirect" lending through an institutional intermediary. As only a small portion of the "current" deposits are normally withdrawn, the financial institution can safely earmark a fairly large proportion of these "costless" funds for the purchase of government securities.

Interest-free bonds, however, cannot play the same role as conventional bonds,since interest rates and hence of costs of credit cannot be influenced through open-market operations. Although the cost element ceases to be a monetary policy variable under the Islamic scheme, even the interest-free Islamic Bonds can be regulated' in such a way as to influence the monetary situation by indirectly controlling the availability of funds. This may be achieved through legislative powers vested with the Central Bank to vary the statutory requirements with respect to the ratio government securities that bank and non-bank financial institutions are obliged to carry in their "advances" portfolios. As a tight money policy measure, the Central Bank may raise this ratio so that investible funds of financial institutions can be effectively frozen. As an easy-money policy measure . this ratio may be lowered in order to make more funds available for private investments. This obviously implies that credit creation by the commercial banks will be allowed to continue even in an Islamic framework.

The legitimacy of the commercial banks' power to create deposits in an Islamic economy still remains a matter of unsettled controversy. Perhaps attention in the future needs to be focussed not just on how legitimate such credit creation is but on adjustments in the pattern of ownership, control and distribution of profit in the banking sector so as to lend legitimacy to credit creation if it is to be recognized as an integral function of the commercial banks.

3D.  The Scope of Monetary Policy

Monetary policy in modern times seems to have regained the respectability it had lost under the Keynesian assault. Friedman and his disciples, in asserting the potency of monetary policy, have emphasized that the crucial variable is the stock of money, and not the rate of interest. This message of the new monetarism has far-reaching implications for the role of monetary policy in an Islamic economy where interest rate is totally illegitimate.

The volume of money can be varied, for example, through the sale/purchase of government securities to/from financial institutions and through adjustments in the statutory ratio of such securities in the "advances" portfolios, as mentioned earlier. In inflationary times, a rise in this ratio will siphon off a large proportion of the excess money which has been depositd with financial institutions. In addition, the Central gank may give directions to financial institutions regarding the volume and compsotion of their financial commitments. All such restrictive measures may effectively curtail the availability of funds for investment. But in times of depression, funds unlocked through the government purchase of its bonds may not necessarily stimulate investment activities, if pessimistic business expectations prevail.

Although the monetary policy as outlined above is seemingly asymmetrical in its impact. the unique character of the Islamic monetary system, discussed earlier, tends to make the monetary policy a double edged weapon. For. the financial institutions in an Islamic economy, being essentially profit-sharing and equity-seeking institutions, play an active role in contrast with the passive role of conventional financial institutions outside the Islamic set-up. The Islamic financial institutions can therefore lead the business community and influence the business outlook by injecting confidence and stimulating investments in time of economic recession.

It is. therefore, clear that there is ample scope for monetary policy to play an effective role within an Islamic framework, in spite of the total absence of the interest element. To be sure, an Islamic economy is at no terrible disadvantage vis-a-vis a non-Islamic economy with respect to the efficacy of monetary policy, especially in view of the dubious macrocconomic stabilization role of interest rates. One may even argue that monetary policy may perform better in an Islamic system, because of the unique nature of the system itself, as shown, for example, by the symmetrical impacts referred to earlier.

This is not to deny that monetary policy has limited applicability regardless of whether it is in an Islamic economy or not. For instance, the question of the lag between policy action and the desired effect has led many monetarists not to recommend discretionary monetary policy has led many monetarists not to recommend discretionary monetary policy for stabilization purposes.

In an Islamic set-up, the principal substitute for money is goods and services and the transactions motive accordingly dominates as in the Classical system. But. unlike the Classical system, in an Islamic system the velocity of money circulation cannot be constant, simply because of the islamic stance on consumption, which reduces to some extent the vulnerability of the goods and services market to the monetary stimuli. Monetary expansion does not necessarily lead to substantial consumption expansion, since Islam frowns upon extravagances and excesses in consumption, so that velocity of money falls. Nor docs monetary restriction result in any remarkable reduction of consumption expenditure, because consumption tends to be always on a somewhat low gear with little scope for significant contraction, so that the velocity of money rises. Velocity changes would therefore offset, at least partially, changes in money supply. The implication is that monetary policy will be ineffective, as suggested by the Keynesian analysis.

In any case, an Islamic economy is relatively more stable than its capitalist counterpart. Since saving and investment decisions in an Islamic economic system are interdependent, and not independent, the divergence between saving and investment is not pronounced. This implies greater economic stability, now that differences between injections and leakages in the circular flow of income are minimised. Since consumption is always placed on a relatively low-key basis in an Islamic society, the marginal propensity to consume is somewhat low, and a low cosumption propensity implies a rather weak multiplier mechanism which does not permit economic disturbances to be magnified. This considerably reduces the amplitude of economic fluctuations. 

Moreover, in the Islamic system the danger ot general prices being pulled up by demand is not as great as in the case of a capitalist economy, in view of the relative stability of its consumption expenditures which are comparatively insensitive to changes in the stock of money. In the same vein, the danger of general prices being forced up by monopoly elements is less serious in an Islamic system. For, attempts to push up the prices ot commodities in a unilateral fashion to make excessive profits is completely alien to Islamic ideology.

4.

SUMMARY AND CONCLUSION

It might appear at first sight that there is scarcely any scope for monetary policy in an interest-free economy. For, interest rate is believed to be such an important variable influencing the demand for and the supply of money that its absence would render the monetary policy completely impotent and invalid as a macroeconomic weapon. That this is an erroneous view is implicit in our analysis in Section 2 which suggests that the faith in the interest rate as a monetary policy instrument variable is really misplaced.

New monetarists of the Chicago school of thought stress that it is the .stock of money, and not the rate of interest, which is most important. This revelation has important implications for an Islamic economy which denies any role to interest rate.

In an Islamic society, excess money balances may go largely into "tendings" or investments in direct or indirect forms. The third possibility of "hoarding" represents an insignificant outlet not only because idle resources imply economic wastes that Islam abhors but also because there are negative real returns on idle money balances owing to the erosion in the value of money over time. "Landings" to financial institutions in the form of "current" deposits or "indirect lendings" to the government in the form of bond purchases carry no real return, while direct and indirect investments carry positive returns in the form of profits or negative returns in the form of losses. The monetary authorities may vary the quantity of money in such a way as to influence lendings and investments.

As the consumption pattern is unlikely to be affected significantly by changes in the volume of money in an Islamic society which discourages extravagances and excesses in consumption habits, surplus money will be channelled into productive purposes, if such opportunities exist, or may simply lie idle either in the form of household hoarding or unused lendings in financial institutions. The implication is that the velocity of money circulation might fall. Conversely, a tight money situation may not witness marked reductions in the demand for goods and services, since the consumption pattern in an Islamic system is always on a low profile, implying that existing stock of money will be used more efficiently to finance a bigger volume of transactions so that the velocity of circulation would rise. Velocity changes may thus neutralize the monetary measures.

Although the spirit of the new monetarism of the Chicago school, which plays down the role of interest rate and emphasizes the impact of the money stock changes, would seem to appeal to Islamic scholars who seek alternative monetary system, the present analysis seems to support the Keynesian conclusion that velocity changes may negate the changes in the volume of money, questioning the potency of monetary policy in an Islamic economy. Nevertheless, we must hasten to add that monetary policy has serious limitations not only within an Islamic framework but also without it.

It. however, appears that the probability of cyclical fluctuations is comparatively small in an Islamic economy, since the Keynesian ex-ante divergence between saving and investment, caused by the divergence between "market" and "natural" rates of interest, does not arise. The risk of inflation, in particular, appears to be minimal in an Islamic economy. The demand-pull variant of inflation has relatively little relevance in the present context, because more money does not necessarily result in significant increases in consumption expenditures in an Islamic system which discourages conspicuous consumption and excesses in expenditure. Thus the question of "too much money chasing too few goods" would not apse significantly. Likewise, several variants of cost-push inflation also appear to be largely irrelevant, since Islam would not permit monopoly power to be abused to raise prices unilaterally.

The following conclusions are therefore difficult to resist. First, an Islamic economy is not significantly worse-off than its non-Islamic counterpart with respect to the potency of monetary policy, not only because monetary influence can be exerted through variations in the money stock per se even in the absence of the interest rate variable, but also because the role of interest as a macroeconomic variable is being played down even in modern monetary analysis. Second, an Islamic economy is perhaps even better-off in the sense that the need for such a policy is felt somewhat less, as the economy tends to be relatively stable.

The two basic assumptions underlying the above analysis are (a) the existence of a low consumption profile and (b) the absence of a serious divergence between saving and investment in an Islamic set-up. These assumptions might appear to be too simplistic and unrealistic at first sight. It may also be argued that the marginal propensity to consume would increase with a more equitable distribution of income. While there may be nothing un-Islamic about such an outcome, one cannot deny that the consumption function and hence the consumption pattern in an Islamic economy would significantly differ from that in a capitalist one. In particular, Ducscnberry's demonstration effect would have limited applicability in a truly Islamic economic order.

While most Muslim economists seem to concede that the consumption function in an Islamic economy will be unique, they may not be prepared to accept that it will also be inherently stable. It cannot be denied, however, that the value attached to simple way of life in the Islamic socio-economic order is an important determinant of the consumption pattern in an Islamic economy. Especially in the presence of good business opportunities, free from abnormal risks, the Islamic virtue of thriitiness can be easily practised.

The divergence between saving and investment in modern times are largely the result of the fact that savers and investors are different entities. But the distinction ''between the two can be blurred through institutional arrangements in an Islamic economy. If depositors would also account for the ownership and control of the financial institutions, the gap between saving and investment can be considerably  reduced. This does not, however, mean that disequilibrium between saving and investment can be entirely ruled out even in an Islnmie economy. This merely suggests that such a disquilibrium in an Islamic economy is unlikely to he as serious it would he in a capitalist economy.

Finally, a word of caution is in order. While the hanking system in an Islami economy can operate efficiently on the profit-sharing principle and the profit rate can effectively substitute the allocative function of the interest rate, the profit rate cannot obviously he used as a macroeconomic weapon, quite unlike the interest rate In other words, the profit rate cannot he varied at will by the monetory authority to stablize the economy. This calls for alternative mechanisms. Variations in the volume of money as suggested earlier is one possibility. It however appears that the Central Bank in an Islamic economy will have to rely heavily on selective controls and moral suasion.

Admittedly, the present paper has projected an "ideal" image of the Islamic economy. To accommodate deviations from the "ideal" without at the same time violating the fundamental Islamic principles is beyond the scope of the present paper. Nevertheless, there is no doubt that Islamic ideals are practical and not heroic. It is pertinent to note that many of the economic illness witnessed around the world today arc peculiar to the present economic environment. This means that some of the policy prescriptions with which we are now familiar may well become rcdundaht in the Islamic set-up. Thus the form and the role of monetary policy envisaged for an Islamic economy are bound to be quite different from those that are relevant for the capitalist regime.

COMMENTS

1. Dr. Ziauddin Ahmad  (Discussant)

The paper written by Dr. Mohameci Ariff on the role of Monetary policy in an Islamic economy raises a number of pertinent issues on which further thought needs to he given by Muslim scholars in an attempt to advance our knowledge about the working of an Islamic economy in modern conditions under the norms provided by Islam. The literature on the subject is so scanty that any exploration in this field of study is worthy of our appreciation. Dr. Ariffs paper makes a valuable contribution in this respect and deserves careful consideration.

Dr. Ariffs paper is broadly divided into two parts. In the first part of his paper, he seeks to demonstrate that even in the modern "capitalistic" economic system interest does not perform so vital a function that its elimination will blunt the working of monetary policy. The second part of the paper gives an overview of what the author regards the distinguishing characteristics of an Islamic economy which provide "ample scope for monetary policv in play an effective role within an Islamic framework, in spite of the total absence of the interest elements". It is my own conviction that interest is not an indispensable part of the modern economic system and that it is perfectly feasible to run the economy of a country in the absence of the interest element without any untoward effects on growth or allocative efficiency.

While I am in full agreement with Dr. Ariff in this respect, I am unable to subscribe to a member of ideas in his paper and differ with him on many substantive issues related both to his interpretation of modern monetary theory as well as the working of an Islamic economy. My main purpose in highlighting these points of disagreement is to provoke further discussion on the subject in a constructive spirit and thus to assist in the evolution and development of scientific thought in this admittedly difficult field of enquiry.

Dr. Ariffs main contention in the first part of his paper is that "monetary policv based on interest rate manipulations suffers from serious shortcomings which have severe implications for the efficacy of monetary policy". After a general discussion of some of the Keynesian ideas about money and interest and the main postulates of the new quantity theory of money. Dr. Ariff makes an incontrovertible statement that the effectiveness of interest rate policy "would however depend upon the sensitivity of investment and saving to changes in the rate of interest". He then proceeds to suggest that "If cost-of-credit considerations are totally irrelevant for investment decisions, interest rale variations will have no im/xtcr at all upon the economy. If cost-of-credit considerations are irrelevant within a certain range of interest rates, the usefulness of monetary policv is partiallv impaired. If credit-cost considerations matter in the upward directions onlv, tnonetarv policv becomes asymmetrical in its impact. Indeed, these possibilities cannot be ruled out. " Subsequently he states that "The Kyencsian analysis unambiguoslv suggests that it is the business expectations and not cost-of-credit considerations which strongly influence investment dicisions. " He also cites certain studies which support the view that "investment demand is generally sensitive to changes in the rate of interest. It even appears that tlie cost of capital hardly enters into investment decisions. " These are highly unqualified statements.

The received body of doctrines in the history of economic thought tells us that the interest rate plays an imnportant part in the Keynesian system even though Keynes differed from classical economists in regard to the actual mechanics of his determination of interest rates. Keynes clearly postulated a negatively sloped relation between investment and the rate of interest when in the context of his discussion of the factors affecting the marginal efficiency of capital he said that "the rate of investment will be pushed to the point on the investment demand schedule where the marginal efficiency of capital in general is equal to the market rate of interest." [1] 

As far as the current literature on the subject is concerned, opinions differ widely on the sensitvity of investment expenditures to ehanges in interest rates and other manifestation of credit restraints. Construction expenditures account for as much as one half of gross private domestic investment in some industrially advanced countries so that interest is an important element in determining the overall level of economic activity in such countries. As against construction, there is less agreement about the sensitivity of busdiness spending to changes in interest rates. Investment in inventories tends to be relatively intcrest inelastic because businessmen expect investment expenditures in this category to pay for themselves very soon, though even in this case, as the interest rate goes up a point will be reached at which financial costs will begin to make themselves felt in investment decisions. 

In as tar as investment in industrial plants is concerned. Dr. Ariff is right that there are many empirical studies that purport to demonstrate that entrepreneurs do not regard the interest rate as an important factor in their investment decisions. However, it has been pointed out by many economists that there is an obvious drawback in drawing conclusions on the basis of replies of a certain group of businessmen. To the businessman, interest is only one of the many factors affecting the investment decision and typically the businessman does not think of these factors in the same frame of reference as the economist. Moreover, most of the empirical studies of this type relate to highly industrialised countries in which an increasingly large proportion of business investment is financed with internal funds. The sensitivity of investment to changes in interest rates will naturally be higher in less developed countries where business firms have to depend on borrowed funds in greater measure. Even in the case of developed countries, it has been pointed out. on the basis of empirical evidence, that "though corporations are able to rely largely on internal funds during recession and early recovery periods, the proportion of external financing generally rises during late recovery and boom periods, thereby increasing the influence of monetary policy at these times. [2]

It would appear from the above that the influence of interest rate on investment decisions in a capitalistic economy cannot be dismissed out of hand. It is interesting that Dr. Ariff himself revises his stand on the question a little later in his paper when he says that "capital cost considerations may well become important beyond certain level of interest rate so that even marginal changes in the cost of credit are taken seriously into account by potential investors. In other words, interest has to be sufficiently high for monetary policy to be effective". [3]

Dr. Ariff then goes on to suggest that even though a "sufficiently high" interest rate will influence investment decisions and make monetary policy effective, there are "severe constraints upon the permissible level of interest rates" The three constraints that he mentions specifically arc: (a) a high rate of interest raises the cost of debt servicing for the government which implies a heavier tax burden and a more inequitable income distribution; (b) it tends to foster the development of monopolies as they are in a better position to pass on the increased cost of credit to consumers and (c) high rates of interest favour short-term projects and discourage long-term ones. He then concludes the first part of his paper on an affirmation that "All these considerations cast serious doubts on the wisdom of using the interest rate as a monetary policy iinstrument".

I think the constraints to which Dr. Ariff attaches so much importance are really not much of an impediment in the pursuit of a realistic interest rate policy in capitalist countries. In the first place, "high" is a relative term to which Dr. Ariff himself attaches no precise connotation. The level to which interest rate has to be raised to obtain the desired restrictive impact depends on the objective conditions prevailing in particular countries which can differ widely from case to case. Countries which have low rates of inflation and a well-developed capital market can obtain the desired result with modest increase in interest rates, whereas in countries suffering from severe inflation the interest rate may have to be pitched quite high- As for the specific constraints mentioned by Dr. Ariff, they are realy not of decisive importance. The income  redistribution  effects of debt  servicing of national debt can be easily neutralised by appropriate fiscal measures. The growth of monopolies can be curbed by appropriate legislative action. The disincentive effects of high interest rates on long term projects can be softened by a number of fiscal devices. 

It seems to me that for vindicating Islam's position on interest it is really not necessary to demonstrate that the interest rate weapon is not of much use even in capitalistic economies. Attention needs to be concentrated on a comparative evaluation of the mechanisms that are employed to achieve the objectives of monetary policies in an Islamic economy as distinguished from those employed in capitalistic or centrally planned ecconomies. Growth, allocative efficiency and distributive justice are the criteria on which such a comparative evaluation needs to be based. There is vast scope for both theoretical and empirical research in this field.

The second part of Dr. Ariffs paper contains a number of observations about the nature and characteristics of an Islamic economy which have a bearing on the scope and efficiency of monetary policy. His main thesis is that the probability of cyclical fluctuations is comparatively small in an Islamic economy which, lor this reason, tends to be more stable than a capitalistic economy. He therefore feels that in such an economy the need for an active monetary policy would be felt somewhat less compared to other market economies. As tor the effectiveness of monetary policy in the framework of an Islamic economic system, the author is of the view that the absence of the interest element does not constitute much of a handicap "in view of the dubious macro-economic stabilisation role of interest rates", and  that the necessary control can be exercised through variations in the money stock perse While I find myself in substantive agreement with Dr. Ariff in respect ol the main theme of this portion of his paper, there are a number of points on which I feel further consideration is needed.

Dr. Ariff advances two mam reasons for proving his point that an Islamic economy would be more stable and less susceptible to cyclical fluctuations. The first reason he gives is that "Since savings and investment decisions are not completely independent in an Islamic economy, the Keynesian divergence between saving and investment and hence the major cause of cyclical fluctuations, does not arise significantly". The second reason is stated by Dr. Ariff in the following words: "Since consumption is always placed on a relatively low-key basis in an Islamic society, the marginal propensity to consume is somewhat low. The relatively low consumption propensity implies a rather weak multiplier mechanism which does not permit economic disturbances to be magnified. This considerably reduces the amplitude of economic fluctuations."

I feel that both these propositions can be taken as interesting hypotheses on which further work would need to be done before one could say anything really definite about them. Dr. Ariff provides node-tailed justification for his belief that saving and investment decisions are to a large extent interdependent in an Islamic economy. It seems to me that he has taken this position because the institution of Zakah in Islam impels savers not to keep their capital idle. Thus he says "Islam does not tolerate economic waste and hoarding is therefore vehemently discouraged, while the Islamic fiscal device of Zakah in a sense penalises those who hoard. All these imply that the gap between saving and investment is minimised." The main point for consideration here is whether it can he assumed that all (he saving which is put at the disposal of financial institutions in an Islamic economy would get actually invested. My feeling is that since under modern conditions savers and investors are bound to be different entities, such an equilibrium cannot be taken for granted.

The proposition that an Islamic economy will have a low propensity to consume and hence a low value of the multiplier also deserves further consideration. It is true that Islam frowns upon extravagance and excesses in consumption. However, despite the practice of austerity on the part of the affluent sections of the population.' the marginal propensity to consume of an Islamic economy can be quite high if it is at a low stage of development and the pattern of future development is such that most of the benefits of growth accrue to the low income groups who on account of large unsatisfied demand have usually a high marginal propensity to consume.

Certain other propositions advanced by Dr. Ariff stand in need of even closer scrutiny and appear to be ot doubtful validity. While discussing the demand tor money he says that "In an Islamic economy the substitute lor money is essentially goods and services as in the case of the Classical economic system." There is no reason why this should be considered axiomatic. There is nothing to preclude the existence of a well-developed capital market in an Islamic economy so that recipients of money balances have a choice either to spend them on goods and services or to purchase non-interest bearing financial scrips. Similarly, it is difficult to agree with Dr. Ariff when he says that "in the Islamic system the danger of general prices being pulled up by demand is not as great as in the case of a capitalistic economy, in view of the relative stability of its consumption expenditures which are comparatively 
insensitive to changes in the stock of money." The behaviour of consumption enditures in an Islamic economy consequent to changes in, the stock of money not he generalised in this fashion, and in the case of low-income countries one may well find a very close correspondence between the changes in  the two magnitudes.

Dr. Arift regards saving to be invariant with respect to changes in interest rates and is of the view that "in an Islamic society, people save mainly because Islam urges its followers to practise thriftiness in spending and moderation in consumption." Empirical evidence in regard to interest elasticity of saving is indeed inconclusive, fjowevcr. a number of studies point to the conclusion that increase in interest rates bvfinancial institutions does lead to greater flow of savings to such institutions. In view of the fact that in an Islamic economy also there would be need for greater mobilisation of savings by the financial institutions, it is worth considering as to what type of a return can be provided to those who deposit their savings in financial institutions.

Two suggestions occur in this respect in Dr. Ariff s paper. One is the conversion of time deposits with banks into equity shares. There is no doubt about its permissibility in Islam. The other suggestion is that banks may pay to the depositors a nominal rate ofreturn equivalent to the actual rate of increase in general prices. According to Dr. Ariff this would not be logically inconsistent with the Islamic ruling on interest : because it would imply zero return in real terms. I have discussed this idea with some religious scholars in my country who are of the view that this is not permissible in Islam. It would be well to give further consideration to this matter in the seminar.

It may be said in conclusion that Dr. Ariff's paper provides a good basis for discussion on the subject of the role of monetary policy in an Islamic economy. He has touched on many issues which have a crucial bearing on this subject. However. there are many more areas that remain to be explored. A major field in which intensive work is needed, and which has remained more or less untouched in Dr. Ariff's paper, relates to the substitution of interest by some alternative? mechanism or mechanisms for the allocation of scarce resources. It is often suggested that in an Islamic economy a system of profit-sharing can take the place of interest. The mechanics of such change-over and its implications need to be studied in depth. In fact it is necessary to work out a complete model of an interest-free economy with all the objective conditions essential for its successful functioning clearly spelt out. This alone can serve as a guide for practical action.

2.  Dr. Mohammad Umer Chapra (Discussant)

Let me at the very outset pay my compliments to Dr. Ariff for a very thought-provoking and well-written paper on the role of monetary policy in an Islamic economy. This paper has no doubt the potential of becoming a worth-while contribution to the field of Islamic economies.

He has very skillfully demonstrated the ineffectiveness of interest rate as an Histrument of monetary policy. The rate of interest is not a double-edged weapon; it is more potent as an anti-inflationary instrument. You cannot induce people to borrow by lowering the rate of interest if the prospects for business are not bright. In Edition, the Keynesian "liquidity trap' reduces the available supply of loanable 'Unds at low rates of interest. In periods of booming businss conditions high rates of 'Merest do not serve as a deterrent unless they are raised to very high levels which would he inimical to economic growth, encourage short-term projects, increase the already heavy interest burden of the public debt and foster the development of monopolies. In addition, there is the problem of the "locking-in" effect. Thus he points out that it would be more desirable to concentrate on regulating the stock of money when thinking of monetary policy. Therefore, the non-availability of the rate of interest as an instrument of monetary policy cannot create any handicap in an Islamic economy. 

He, however, fails to give any consideration to the mechanics of regulating the quantity of money in an Islamic economy. Will the same instruments be used as in capitalism or will there be different instruments. In the capitalist system there are two direct agents for increasing or decreasing the quantity of money - (1) the government, through its deficit financing or borrowings from the central bank (which is the same as printing of notes) and (2) the commercial banks, through their power to "create" deposits. The central bank only tries to change the cost or availability of "high-powered" money to influence the ability of commercial banks1 to "create" deposits. While discussing the subject of monetary policy in an Islamic economy it is important to discuss the question of the commercial banks' power to "create" deposits. Dr. Ariff has implicitly assumed, like most other Muslim economists, that "creation" of deposits by commercial banks will be as legitimate in an Islamic economy as it is in its capitalist counterpart.

This raises a very important question to which I hope the scholars attending this seminar will give their due attention: should Muslim economists carty on their analysis within the framework of the capitalist system or should they tear apart the different ingredients of the capitalist system to see whether they really fit into, or conflict with, the value system of Islam?

Another problem I face in Dr. Ariff's paper is that he has made a number of unrealistic assumptions about the operation of a Muslim society: some of these assumptions are really unnecessary for the final conclusions he has drawn. For example, to explain why people would save in an Islamic society without the interest reward he explains that the "low posture in consumption'" being a way of life, "the abstinence explanation of interest loses its theoretical appeal." This explanation is not realistic. Throughout Muslim history we have seen that people who have had high incomes have not led a simple life. Morever, absence of interest does not necessarily mean the absence of return on savings. Islam is not an advocate of Marx's concept of "surplus value". Islam recognises return on capital through sharing in the risks of business. Dr. A riff does mention profit in a later part of his paper but does not build that into his model to show why people will save in the absence of interest.

While the value of a simple wav of life may be a part explanation for savings in a Muslim society, a major part of the explanation would lie in the availability of investment opportunities and sufficient return on investment to offset the risk and the eroding effect of inflation. In a Muslim society like Saudi Arabia with high incomes and low business opportunities, combined with unattractive international stock markets and undesirable exchange risks, consumption is bound to be an attractive alternative compared with savings eroded by inflation. Hence savings would not be high in a Muslim society just because of the value attached to a simple way of life. They would be high if investment opportunities were available and if the rate of return is adequate.

Another simplification and unnccssary assumption is that hoarding of idle balances will he minimized because hoarding is discouraged in Islam and idle wealth is penalized by Zakah. Even Muslims in an Islamic society will prefer to hold idle balances and not invest them if they face prospects for incurring losses.

In addition to a number of simplistic assumptions, there are some errors of judgement. He has advocated indexation of financial assets to offset the effect of inflation. If indexation is recognised for financial assets then in the Islamic-framework of justice it should also apply to every income or asset the value of which erodes away due to inflation. If we do not recognize indexation for all these why should we recognise it for only finance? Will this not conflict with the concept of "justice" in Islam?

Dr. Ariff has assumed that velocity (V) cannot be constant in an Islamic society because of the Islamic stance on consumption (C); consumption expenditure will be comparatively insensitive to change in the stock of money (M). Hence, if M rises then V goes down because C remains constant, and vice versa. The changes in V will thus neutrali/e the changes in monetary stock. This leads him to the conclusion that monetary policy will be ineffective in an Islamic economy. Therefore, the gist of his reasoning would be that of the two constituents of monetary policy, interest and money stock, interest is ineffective even in capitalism and has no place in Islam, anil changes in money stock will be ineffective because they will be neutralized by changes in V. This undoubtedly conflicts with his earlier conclusion where he states that monetary policy could be activated without having to draw the interest rate into the picture by influencing the stock of money.

Such a conclusion would of course create a pessimistic note; however to offset this he argues that "In any case an Islamic economy is relatively more stable than its capitalistic counterpart" because divergence between S and I will not be pronounced in an Islamic economy. He argues that the probability of cyclical fluctuations is comparatively small in the islamic economy. He tries to do a valuable job here but remains unconvincing because of a number of unrealistic assumptions about consumption, saving, and investment.

Therefore, while I have no qualms about admitting both the conclusions he has given in the second last part of his paper, I feel that the conclusions are not really borne out by his analysis in spite of being skillful and valuable. The same conclusions could have been reached without the unrealistic assumptions he has introduced.

I feel that some additional work would further raise the quality of this excellent paper and make it an extremely valuable contribution to Islamic economies.

GENERAL DISCUSSION 

• Dr. Mohammed Omar Zubeir disagrees with the author on the point that there is no room in Islam for speeulation of any type. He stresses that speculation which reduees fluctuations in prices would be compatible with the Islamic spirit ot justice.

He also does not agree with the author's suggestion that the debtor compensates the creditor for erosion in the value of money due to inflation. Heis ot the opinion that this is not permissible in Islam.

Dr. Zubeir also finds it difficult to accept the author's postulate that the marginal propensity to consume in an Islamic economy will be less than that in a Western society. On the contrary. Dr. Zubeir argues that the prohibition of interest and the discouragement of hoarding would tend to raise consumption in a Muslim society to a level higher than that in non-Muslim societies.

• Dr. Mohammed Umer Chapra, too, rejects the author's assumption that the consumption level in an Islamic society will be relatively low. He even suggests that the opposite is probably closer to reality. He postulates that the lack of well-developed money markets and of business opportunities in an Islamic society will encourage the Muslims to spend more to offset the risk of erosion,in the value of money due to inflation. He cites the example of the oil-rich Muslim countries where Muslims are as much subject to luxuries in consumption as those in non-Muslim countries.
  

Notes and References

1. J.M. Keynes, I'ract on Moinetary Reform, Macmillan. (London) 1923.
2. J.M. Keynes. The Treasure on Money. Macimillain. ( London ) 1930.
3. J.M. Keyness. The General Theorey of Emplyment, Interest and Money, Macmillan, (London) 1930.
4. M Friedman. "The Quantity Theory of Money; A restatement" in Friedman (Ed. ).Studies in Quantity Theory of of Money, University of Chicago Press. (Chicago) 1956.
5. T. Wilson and P.W.S. Andrews (eds.). Oxford Studies in the Price Mechanism, Oxford University Press, (London) 1951 and J.F. Ebersole. "The Influence of Interest Rates Upon Hntrcpreneuruil Decisions in Business--A case Study." Harvard liuxim'xs Review. Autumn, 1938.
6. G.K. Shaws, An introduction to the Theory of Macrocconomic policy, (London) 1971, p. 72
7. Ibid .. p. 74.
8. J.K. Galbraith, "Market Structure and Stabilization Policy", Review of Economics and Statistics. May 1957.
9. V. Argy, "The Impact ot Monetary Policy on Expenditure with Particular Reference to the United Kingdom", IMF Staff papers. November. 1969.
10. The national return on "lending" will be zero it the general price index is absolutely stable.

Comments

Notes and References

1. J. M.  Keynes: The General Theory of Employment,  Interest and Money, (Harcourt, Brace and Company) pp. 136-137.
2. The Report of the Commission on Money and Credit. Committee for Heonomie Development. U.S.A., (Prentice Hall. 1961) p. 52.
3. The author does not give equal attention to the effects of lowering of interest rate on investment  decisions except to note that "Relatively low interest rates may not stimulate new investment if  business outlook is extremely gloomy".