MBF707: Monetary and Fiscal Framework in Islamic Finance COMSATS Institute of Information Technology (Virtual Campus)

Lecture 29 The Financial System and Monetary Policy in an Islamic Economy (Theoretical Model) 2

Topics Covered  Modes of Financing  Role of Central Banking 3

Topics to Cover Theoretical Model  Conventional Structure of MP  Structure of the model a. Banking sector b. Central bank c. Public sector  Behavioral Relationships 4

The IS curve def: a graph of all combinations of r and Y that result in goods market equilibrium, i.e. actual expenditure (output) = planned expenditure The equation for the IS curve is:

Y2Y2 Y1Y1 Y2Y2 Y1Y1 Deriving the IS curve  r   I Y E r Y E =C +I (r 1 )+G E =C +I (r 2 )+G r1r1 r2r2 E =Y IS II  E E  Y Y

Why the IS curve is negatively sloped A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (E ). To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y ) must increase.

The IS curve and the Loanable Funds model S, I r I (r )I (r ) r1r1 r2r2 r Y Y1Y1 r1r1 r2r2 (a) The L.F. model (b) The IS curve Y2Y2 S1S1 S2S2 IS

Fiscal Policy and the IS curve We can use the IS-LM model to see how fiscal policy (G and T ) affects aggregate demand and output. Let’s start by using the Keynesian Cross to see how fiscal policy shifts the IS curve…

Y2Y2 Y1Y1 Y2Y2 Y1Y1 Shifting the IS curve:  G At any value of r,  G   E   Y Y E r Y E =C +I (r 1 )+G 1 E =C +I (r 1 )+G 2 r1r1 E =Y IS 1 The horizontal distance of the IS shift equals IS 2 …so the IS curve shifts to the right. YY

Exercise: Shifting the IS curve Use the diagram of the Keynesian Cross or Loanable Funds model to show how an increase in taxes shifts the IS curve.

The Theory of Liquidity Preference due to John Maynard Keynes. A simple theory in which the interest rate is determined by money supply and money demand.

Money Supply The supply of real money balances is fixed: M/P real money balances r interest rate

Money Demand Demand for real money balances: M/P real money balances r interest rate L (r )L (r )

Equilibrium The interest rate adjusts to equate the supply and demand for money: M/P real money balances r interest rate L (r )L (r ) r1r1

How the Fed raises the interest rate To increase r, Fed reduces M M/P real money balances r interest rate L (r )L (r ) r1r1 r2r2

Theoretical Model of the Islamic Financial System  The model incorporates the principal characteristics of Islamic banking outlined earlier in our discussion. This model is modified version of financial models of Brainard (1967), Tobin (1969), and Modigliani and Papademos (1980) which are the standard in monetary theory.  This model discusses the basic accounting structure of the model, the underlying behavioral relationships, and finally, the effects of monetary policy. 17

Theoretical Model 1.Structure of the model a. Banking sector b. Central bank c. Public sector 2.Behavioral relationships 3.Solution of the model 18

A Theoretical Model: Structure of the model  The financial side of the economy is composed of commercial banks, central bank, and the non-bank public.  Additionally, the model contains a single commodity that is both produced and consumed domestically.  For simplicity, the economy is assumed to be closed so that there is no trade or capital movements. 19

Theoretical Model: Banking Sector  Commercial banks will offer only investment deposits to the public which are not guaranteed by the banks and do not yield a predetermined rate of return.  The banks are assumed to pay depositors a rate of return that is based on profits from their operations.  These profits are shared between the depositor and the bank in some mutually-agreed proportion determined prior to the transaction, so that return is the depositor's share of the bank profits as a proportion of his deposit. 20

Theoretical Model: Banking Sector  The rate of return received by deposits will thus fluctuate according to variations in bank profits and/or the stock of deposits. The profit-sharing ratio is assumed to remain fixed for the duration of the contract.  Commercial banks in the Islamic system cannot borrow from the central bank through the mechanism of rediscounting at a given official discount rate.  Banks can borrow from the central bank only on an equity-participation basis. 21

Theoretical Model: Banking Sector  That is, the central bank purchases equity in the bank when it wishes to expand reserves in the system, and vice versa.  Therefore, an additional source of funds for commercial banks becomes the sale of equity shares to the central bank.  The rate of return on equity shares would depend on the overall profit position of banks, so that in contrast to an official discount rate, it would not be determined directly by the central bank. 22

Theoretical Model: Banking Sector  On the lending side banks engage in only risk-return sharing Mudarabah arrangements with the public.  Mudarabah financing in this case is assumed to subsume all other types of similar arrangements, such as Musharaka financing.  As in the case of investment deposits, the profits earned from the projects financed by the bank are shared between the bank and the entrepreneur on a prearranged basis specified in the contract between the two before the financing is provided. 23

Theoretical Model: Banking Sector  The rate of return the banks receive will be related to the rate they pay on their liabilities, with the spread essentially covering operating and other costs.  If such costs are assumed to be zero, the rate of return on loans will be equal to rate of return on deposits.  The banks would thus be receiving profit-sharing ratio in favor of the bank.  Higher share of return to the bank would reduce the demand for loans. 24

Theoretical Model: Banking Sector  Banks are also required to hold a certain proportion of their liabilities to the public in the form of reserves with the central bank.  Whether investment deposits should be subject to legal reserve requirements or not (Debatable)  It is assumed so far that banks hold reserves at the central bank without necessarily implying that such holdings are mandatory. 25

Theoretical Model: Central Bank  The central bank's liabilities consist of reserves of commercial banks.  The high-powered money in the economy is by definition equal to the stock of bank reserves.  On the asset side the central bank holds equity shares of commercial banks, and the rate of return on these is market determined.  The supply of reserves is changed by the central bank through variations in its stock of bank equity shares. 26

Theoretical Model: Public Sector  Since commercial banks are the only financial intermediaries in the economy, investment deposits in the banking system represent the financial wealth of the public.  Total wealth of the public is equal to financial wealth and its stock of capital.  The public has basically two sources of funds: first, Mudarabah financing, and second, its own savings (S).  In the absence of a debt market, any desired increase in assets (financial or total) has to be accommodated through one of these sources. 27

Theoretical Model: Public Sector  Any model that attempts to explain this type of economy would have to necessarily ensure consistency with the flow of funds accounts. 28

Theoretical Model: Behavioral relationships  The monetary policy in an Islamic economy is a variant of the standard IS-LM model.  While relatively simple in structure the model developed is sufficiently general to incorporate the balance sheet restrictions. Three important assumptions: a)All changes in income will reflect variations in real output. b)Expectations of economic agents are fully realized. c)The real and the financial sector are assumed to be in continuous equilibrium. 29

Theoretical Model: Behavioral relationships  IS relationship is derived assuming that investment is a negative function of the rate of return on Mudarabah financing, and savings a positive function of income.  Net wealth at the beginning of the period is assumed to affect both investment and savings, with the former effect dominating. 30

Theoretical Model: Behavioral relationships There are three financial assets in the LM model: a)bank loans b)investment deposits c)equity shares of commercial banks.  The public's demand for Mudarabah financing is specified as a function of the banks' required rate of return, and net wealth at the beginning of the period.  The banking sector's supply of Mudarabah financing can be specified as a positive function of the rate of return, and a negative function of the cost of borrowing for banks. 31

Theoretical Model: Behavioral relationships  This cost will be effectively the rate of return on the banks equity shares held by the central bank.  The sale and repurchase of its equity is the only way a bank is assumed to be able to augment or reduce its resources.  This operation is equivalent to the use of a rediscounting mechanism, or quasi discount rate. 32

Thank You 33