Role of Monetary Policy

In the conventional economic system, there are essentially three forms of money: coins, bills, and bank deposits. In such a system, the central bank can pump money (bills and coins) into the economy through banks; banks in turn can lend the money to investors (and consumers); and when and if banks increase their lending, investment increases, lifting national output. But we need to explain in more detail the structure of the banking system in such an economy, why bank deposits are considered money, and in turn how banks create money.

When a person deposits $100 in a bank checking account, the bank issues that person checks; he or she can in turn write checks up to $100 and use them just as if he or she had cash. But the bank does not stand still; it lends as much of the $100 that person deposited to others and charges the borrowers interest; central banks limit the percentage of money deposits that banks can lend by requiring them to hold a proportion of the $100 as reserves (the reserve requirement). If the reserve requirement is, say, 10%, the bank can lend out $90; the borrower takes the $90 and deposits it in a bank and can write checks on it. The bank now lends $81 (90% of $90) to another borrower; and so the process continues. Of course, there may be some leakage from the system we have described—borrowers not depositing all the money they borrow and/or the bank not lending out all the cash that is deposited. But the story should be clear: The original $100 injected into the money supply does not stay as $100, but banks use it to create more money in the form of demand deposits; in fact, if the reserve requirement is 10% and if there is no leakage, $100 creates $1,000 ($100 × 1/1 – 0.9) in demand or bank deposits. Thus such a banking system, referred to as the fractional reserve system, creates money. In other words, the $100 is leveraged into $1,000 of demand deposits (through interest-based loans).

The central bank in the conventional system uses a number of tools to affect the money supply and interest rates. The primary instrument of a central bank's monetary policy is open market operations, which is buying and selling mainly government Treasury bills, corporate bonds, other securities, and foreign currencies. Secondary instruments are lending through the discount window (lender of last resort), the changing reserve requirement of banks, moral suasion, and changing market expectations through press conferences and other such means. Through open market operations, the central bank changes the money supply (increasing the supply by buying securities for cash and decreasing it by selling securities on the open market) by selling and buying securities in the market in order to achieve a short-term interest rate target, such as for the federal funds rate, the rate for overnight interbank lending. The central bank as a lender of last resort affects bank lending and interest rates by changing its discount rate, the interest rate at which it lends to member banks when they are temporarily caught short of funds. The money supply can be increased or reduced by reducing or increasing the reserve requirement of banks. Banks can be also “persuaded” to act in ways that the central bank wants, and money markets and expectations can be affected by targeted speeches and interviews. Central banks use announcements especially to affect expectations about inflation (and interest rates) as high inflationary expectations can become a self-fulfilling prophecy.

The upshot of monetary policy in the conventional system is summarized in Figure 11.1. The central bank can raise the money supply from point A to point B, lowering interest rates; this increases investment from C to D; and the higher level of investment raises gross national product (GNP) from E to F. We should note that the impact of monetary expansion is also reflected in what is called the quantity theory of money:

where

1. M = Money supply
2. V = Velocity circulation of money or income velocity
3. P = Average price level
4. Q = Real GNP

V, the velocity of circulation of money, is the rate at which the money stock is turning over per year to enable income transactions. The crude version of this theory is that V is a constant so that a doubling of M leads to a doubling of P. But in real life V is not a constant. The more sophisticated view of this relationship is that an increase in M results in an increase in PQ, which is the dollar or money (nominal) GNP. Thus in Figure 11.1, the velocity, V, is a little lower from E to F, but not enough to keep the new MV and GNP from being higher.

An important consideration in the implementation of both monetary and fiscal policy has been the trade-off between unemployment and inflation. In 1958, William Phillips plotted historical data on wage inflation against unemployment and found what appeared to be a trade-off: If the central bank wants to attain full employment, it may have to put up with more inflation, indicating a trade-off between unemployment and inflation. This relationship came to be known as the Phillips curve. (See Figure 11.2.) Economists generally accepted the relationship until the 1970s when the United States experienced stagflation (unemployment coupled with high inflation) and Milton Friedman and others questioned the validity of the trade-off portrayed in the Phillips curve. They argued that the Phillips curve was only a short-run relationship; in time, inflation would be taken into account by labor, and labor contracts would incorporate anticipated inflation. Thus, with monetary expansion, unemployment would go back to its original level but with higher inflation. The implication is that there are a series of short-run Phillips curves and, in the long run, there is no trade-off between unemployment and inflation. In other words, the long-run Phillips curve is vertical, as shown in Figure 11.2. In the long run, only a single rate of unemployment, the nonaccelerating inflation rate of unemployment (NAIRU), is consistent with a stable rate of inflation that can be attained. With unemployment rates below NAIRU, inflation accelerates. With unemployment above NAIRU, inflation decelerates. With the unemployment rate equal to NAIRU, inflation is stable. In other words, monetary policy affects prices but not real values like output and unemployment. The practical implication is that central banks should not try to reduce unemployment below its natural rate; if they do so for any length of time, inflationary expectations will rise and will be incorporated into wage demands, resulting in higher inflation.

As we have seen, monetary policy is a process undertaken by the monetary authority to control the money supply and the cost of money to achieve the stability of the economy. Central banks serve as lenders of last resort to the banking sector when and if financial institutions or the financial system is under threat. In undertaking an expansionary monetary policy, the central bank seeks to expand the monetary base—consisting of money in circulation and the banking sector reserve with the central bank—by injecting liquidity in the economy. This can be done by reducing the reserve requirements of the banking sector or through open market operations (as described earlier): either through large purchases of financial instruments such as government bonds or direct lending to the banking system with low discount rates, thereby increasing the amount of cash in the system. This mechanism works through the banking sector as the transmission agent for the expansionary monetary policy. A reduction in the discount rate or reserve requirement signals a green light for the banking sector to expand balance sheets and increase lending, which in turn aim at increased spending by consumers.

Monetary policy must meet certain challenges, notably, dealing with the flexibility of the financial system to react and ensuring the timing and credibility of announcements to affect market expectations. The latter depends on the success of the previously implemented monetary policies, as reputation is an important element in the implementation of a successful monetary policy. The success of this policy also depends on the effectiveness of the transmission mechanism and the independence of the central bank from the rest of the government, especially independence from personal and party political agendas. The objectives of the government as policy makers and the private banking sector may not converge. When the banking sector does not transmit the increased liquidity to the rest of the private sector and consumers, but instead uses the liquidity to enhance its own bottom line, then the transmission mechanism has failed. In other words, conventional monetary policy is indirect in that it relies on the banking sector to support and implement the wishes of the central bank. Moreover, within the context of a fractional reserve banking system, the role of the central bank in the course of implementing its monetary policy makes the current conventional financial system unstable and vulnerable to financial turmoil through the expansion of credit out of thin air, which in the end results in excessive leveraging and a debt crisis. Interest rates set by the central bank create a wedge between the money interest rate and the natural rate of interest. Monetary injection allows money capital to multiply independently of real or physical output. Creation of credits not backed by the real economy diverts real savings from productive activities to nonproductive ones that in turn weaken the process of real wealth expansion.

The challenge in an Islamic framework is to design instruments that satisfy the requirements of an effective monetary policy while meeting the rule of exchange-based transactions without resorting to the interest rate mechanism. The solution is to devise financial instruments that rely on the risk-sharing features of equity finance, as discussed in Chapters 8 and 9. Where monetary policy in a conventional economy uses interest rates to indirectly regulate the money supply, in an Islamic economy money supply is directly altered through asset market activities. The incentive structure intended by monetary authorities to induce portfolio adjustment may be distorted if signals are not transmitted to the private sector by the banking sector. For example, the excess reserves arising from a lowering of the reserve requirements may be used by the banking sector to buy government bonds instead of lending to the private sector to increase consumption and investment. As a result, the effect of the monetary policy may not be fully achieved. The use of the interest rate as a tool of monetary policy creates incentives for financial decoupling. Risk-sharing instruments can avoid this problem. Such instruments, issued by the government to finance its operations and used by the monetary authority to affect portfolio adjustment by the private sector, can achieve the objectives of monetary policy while promoting greater resilience of the economy to shocks.

Monetary Policy in an Islamic Economy

In an Islamic economy, the conventional tools normally available in a conventional modern economy are at the disposal of the monetary authorities with the exception of the discount rate and other policy tools that involve an interest rate (buying and selling of interest-bearing bonds). All other tools, namely open market operations (where equity shares rather than bonds are traded) and credit policies, can be as effective in an Islamic system as they are in the conventional Western system. The authorities in an Islamic system can utilize reserve requirements and profit-sharing ratios to achieve changes in the stocks of money and credit. Moreover, as we shall see, monetary policy could be considered to operate through a more direct channel in the Islamic financial system.

The principal goal of monetary policy is to ensure macroeconomic stability, characterized in the main by price-level stability and a viable balance of payments position. The establishment of a stable macroeconomic environment is a prerequisite for increased savings, investment, and foreign capital inflows—all of which are central to the growth process. Basically, without macroeconomic stability, economic growth can falter and not be sustained. Furthermore, without broad-based economic growth, the basic structural and social transformations that make up the process of Islamic development will not occur, and the other objectives of Islamic society, such as a more equitable distribution of resources and income, providing useful employment, improving living standards and the quality of life, and the alleviation of poverty, are unlikely to be met.

In Figure 11.3, we depict the transmission of monetary and fiscal policy in the Islamic financial and economic system. The central bank, by buying and selling risk-sharing securities, directly affects the financial portfolio of the private sector—households and firms—and indirectly affects the holdings of banks and conditions in capital markets that in turn affect real economic activity. The decisions of households and firms impact the real rate of return in the economy, which again affects economic activity, while financial signals to capital markets through central bank policies affect the availability of real resources for investment.

As discussed earlier, the Islamic banking system or financial intermediation is by design a 100% reserve banking system. Banks cannot create money as in the fractional banking system. Moreover, in the Islamic system, there are no interest-bearing debt instruments. Thus, a different set of instruments must be used to affect monetary policy. Monetary policy in the Islamic system has broader objectives than monetary policy in the conventional system. Yes, although nudging the economy to full employment with low inflation is important, Islamic principles expect more. They expect that monetary policy should also support preservation of the purchasing power of money, poverty eradication, a tolerable gap between the rich and the poor, and an adequate social safety net. As we have said throughout this book, the rights of individuals in every generation must be preserved, and all under a general umbrella of social justice where everyone has the bare necessities of life—food, shelter, and healthcare. While the focus in this chapter is on the acceptable instruments (in place of interest-bearing debt instruments) that can be used in open market operations, these broader objectives must be supported.

When revenue is insufficient to cover a budget deficit, the government must borrow. Due to the prohibition of interest in an Islamic economy, the policy instrument for public sector borrowing should be based on risk sharing or through asset-linked financing (i.e., sukuk [Islamic bonds or ownership certificates]). The benefits of risk sharing are manifold, as discussed. Instead of borrowing, the government could promote public–private sector partnerships to finance development projects. This would mobilize higher private sector savings in many countries to support productive public sector investment projects. By issuing risk-sharing instruments to fund development expenditures, the burden of debt could be reduced. At the same time, the household sector would be able to enjoy a higher rate of return on its savings because the rate of return on the papers would be driven by the return to the real sector.

The first best instrument of risk sharing is the stock market. With an active stock market, individuals can buffer idiosyncratic liquidity shocks by selling equity shares in the market. When risk is spread among a large number of participants through an efficient stock market, closer coordination between the financial and real sector is promoted. Moreover, the benefits of economic growth and financial system stability are better shared. Risk sharing through equity finance will ensure that Islamic finance is anchored to the real sector at all times. As discussed earlier, another segment of capital markets, securitized financing or asset-linked securities such as sukuk, play equally important roles in financing of the real sector. The market for asset-linked securities can also be an important instrument of monetary policy execution.

Using the same concept, liquidity in the economy through the monetary policy mechanism can be controlled through the issuance of financial instruments, such as equity participation shares or asset-linked securities, which enable investors to participate in financing government expenditures, such as in development projects. The papers must have low enough denominations and be traded in secondary markets so that ordinary citizens—not just institutional investors—can have access to them (enabling a more direct and predictable impact of monetary policy). To contract the money supply, these papers would be issued directly to the market to mop up excess market liquidity. The effect would be immediate, and leakages arising from intermediation would be reduced. Conversely, if the goal is to increase money supply, the monetary authority would buy these papers from the private sector.

The rate of return on these papers would be referenced to the rate of return to the real sector of the economy. The rate could be benchmarked against the average rate of return of the stock market or the market for securitized assets, which is generally higher than the interest rate in the economy, and hence this presents investors with a better return on their idle income. For example, in late 2012, the interest rate on government securities in Malaysia was approximately 6%, while the rate of return on bank deposits was 2%. If the rate of return on equity participation shares could be set to reflect the equity premium in the stock market (between 9% and 11%), it could potentially earn 7% to 9% (adjusted for the government's risk premium). An alternative could be that the rate of return to these papers could be benchmarked on the return to the real sector of the economy. Either way it would represent a better investment alternative for investors. In countries such as Malaysia, where private savings are high, resources that are earning 2% return could be mobilized to productive use in the economy for a higher rate of return. The effect of this policy measure would be not only to achieve a more potent monetary policy impact than in the conventional economy; it also would serve as a measure of improving income distribution by providing members of society better access to the benefits from the growth of the economy. It would also serve as a consumption-smoothing instrument (to mitigate idiosyncratic risk) for small investors.

These papers should be openly traded in the secondary market so that holders can redeem or liquidate them by selling them at prevailing market prices. This means that institutional investors, such as banks, would have to pay the market price to have access to this instrument for purposes of managing their asset portfolios. In this way, the same economic opportunity would be available to all; it would not be limited to the more financially able. At the same time, the opportunity (risk–reward profile) in economic activity would be available according to the financial capability of each investor. Such monetary policy instruments would also enhance governance, as the government would be more accountable to the general public regarding its investments in the risk-sharing instruments.

The cost to the government of raising financing through equity participation shares would be not much higher than the current rate of interest paid on debt instruments, but it would provide a better impetus to grow the economy by mobilizing funds that would be otherwise idle in deposits. At the same time, these papers could serve as ideal instruments for monetary policy measures (“ideal” in the sense that monetary policy signals would reach the private sector without being filtered by the banking system). To expand the money supply, the papers could be bought from the open market, thereby increasing the amount of money in circulation to increase consumption and investment. An illustration of the mechanism of the Islamic monetary and fiscal policy instruments is provided in Chapter 9.

The monetary instruments that can be used in an Islamic economy are different from those used in the conventional system. Open market operations can be used to buy and sell papers of a different sort because interest-bearing financial debts, such as bonds, are prohibited in the Islamic system. As mentioned, the state can use a number of other avenues to finance expenditures that exceed tax revenues, resulting in securities that can be bought and sold by the central bank to conduct monetary operations. The state can finance all needed capital expenditures through private–public programs, as mentioned: The state could develop the projects and sell equity shares (or national participation papers) for its financing, with stockholders taking the risk and getting the income generated from the project as dividends. Similarly, a number of projects could be combined and equity shares sold for the aggregate number of projects; or, again what is essentially the same thing, the combined projects could be the assets that back a bond that generates a fixed income with the bondholders having access to the underlying assets. Even under conditions where there was no direct revenue from an infrastructural project, the government could resort to private sector financing with dividends paid by the government at (or above or below) the rate of return in the real sector.

The central bank in the Islamic system has other instruments, in addition to our proposed equity shares or participation papers (securitized paper) in development projects, that it can buy and sell in the market to affect the money supply and thus attain its monetary objectives. The major objective of that bank is generation of market-oriented incentives to induce portfolio adjustments to stabilize the economy. These risk-sharing and interest-free instruments work as monetary policy tools to absorb and expand liquidity to and from the economy and at the same time match investors' intentions of investing in Islamic monetary instruments. The available instruments include a variety of Islamic bonds or sukuk (based on ownership in a debt, sukuk al murabaha; in an asset, sukuk al ijara; on a project, sukuk al istisna; in a profit-sharing business, sukuk al musharaka; on an investment, sukuk al istithmar):

1. The state can issue non–interest-bearing bonds (qardh hassan) that the wealthier members of society may want to hold as one of their contributions to overall societal goals.
2. Securities that can be backed by trade-based financing or tijarah (fixed rates).
3. Securities can be backed by lease-based financing ijara (fixed rates).
4. Securities can be linked to real assets that are securitized and the security holder has access to the underlying asset (especially in the event of default). They are of two basic types:
   1. Istisna contracts can be securitized to raise funds based on assets that provide a rental income (such as buildings for fixed income or variables in the case of road tolls).
   2. Salám contracts entail the delivery of specific goods in the future, where the goods are sold to the public on a markup.

As we have elaborated, open market operations, the buying and selling (from the investment bank type of Islamic institutions, and not from the safekeeping category of institutions; more on this below) of equity or securitized assets in projects (participation papers) and asset-linked bonds (sukuk) are expected to be the main instruments of monetary policy, but the central bank can adopt additional tools to affect its monetary stance in the Islamic system. Before we elaborate on these other instruments, we must address two controversial and unsettled issues concerning the operation of central banks in Islamic finance. Are central banks permitted to print paper money, and can they act as lenders of last resort (LoLR)? We believe that the answers to both of these questions are yes. Let us explain.

While some argue that money and value cannot be created out of thin air in Islam, we believe that this proposition can be challenged if money is created to benefit particular members of the community. To our mind, there is nothing in the Quran or in the Sunnah that recommends or prohibits the state from creating money (of course, we realize that there was no paper money at the time of the Prophet (sawa). Yes, the state cannot issue interest-bearing bonds and paper money that earns interest. But if the state prints money in order to facilitate business transactions and enhance prosperity for the benefit of the community because the economy's output is below its potential, then money creation by the state should be permissible. Such a situation can be operationally defined as when there is unused productive capacity in the economy. Also, the central bank can print money to accommodate expected additions to productive capacity. This would mean that there is accurate estimation of full employment output and expected future growth of the economy.

And yes, the state gets the normal advantage of seigniorage, but again if this is used for the equitable benefit of all members of society, not rulers and privileged classes, then why should the central bank be barred from issuing paper money? It is in the interest of the community. Similarly, the central bank should be permitted to act as an LoLR as long as it does not charge interest in order to sustain economic growth. It could charge a financially sound investment bank in need of liquidity a rate consistent with the rate of return to the real sector of the economy ex post facto (thus an actual real rate of return). Alternatively, the central bank could purchase assets from the investment bank, which in the end is akin to acting as an LoLR.

Two things need to be clarified. The banks operate on 100% reserve basis, and there are no deposit guarantees, either for banks that handle the payment system (i.e., those that are allowed to accept demand deposits), or for investment banks (which, even though they are not permitted to take demand deposits, can take investment funds). Those who would not allow central banks to print money argue that the prohibition against money printing is necessary to tie the hands of authorities and monetary policy so it cannot fuel inflation through monetary expansion. But this power is very much limited once the 100% reserve system is the structure of the banking system. The most important point is that a responsible and accountable central bank under a 100% reserve system limits the liability of the government (printing money) to no more than the economy would allow in terms of expansion in productive capacity.

In Table 11.1 we list results of a survey conducted by the Islamic Financial Services Board (IFSB) of 24 regulatory and supervisory authorities (RSAs) where Islamic financial institutions are active and operating. It is evident that the majority of jurisdictions do not have adequate arrangements for providing LoLR due to several factors, such as lack of instruments, lack of threshold of institutions requiring LoLR arrangements, and the relatively small market segment captured by Islamic banks (and thus providing a Shariah-compliant LoLR is not a priority for such RSAs).

A commercial banking system that is 100% reserve banking prohibits lending. The need for reserves and changes in the reserve requirements of these commercial banks as a policy instrument is eliminated. But investment banking affords important policy options: Investment banks channel investor funds into different investment projects (by risk, maturity, rent/dividend, etc.) and issue investors equity shares or bonds (backed by the investments) that are traded in the market. The central bank can affect the operation of these banks in two principal ways. First and foremost, the central bank can buy and sell the securities that it issues directly to investors and those that it issues on its account by investing its own capital. In the case of security purchases, the central bank injects cash into the hands of investors and the banks, resulting in investors and banks having cash to invest in new projects. Note the power of this instrument and compare it to open market operations in the conventional banking system. Here, the central bank puts cash directly into the hands of investors who decide on their investments. In the conventional system, the cash is put into the hands of bankers who may or may not lend. Open market operation is a much more potent policy instrument in Islamic banking than it is in the conventional system. Second, the central bank can change the reserve requirement of investment (mutual fund activities) banks. Investment banks essentially invest the capital of investors in projects of different sorts in a pass-through mode and invest their shareholders' capital in these or other projects. The central bank can require reserves of these investment banks, not because of exposure to risk but to influence investment banks' ability to channel funds into projects and in turn reduce the return to investors. Let us explain. By requiring reserves, these investment banks can invest less of the investors' assets (keeping a part as reserves) and thus reduce the attractiveness of investing (lower rate of return as a portion is kept as reserves and does not earn any return).

Such reserve requirements do raise a number of issues: Should reserve requirements be changed on existing equity investments or imposed only on new investments? Depending on the answer to this question, should these reserves be kept at the central bank and returned to the holder of the equity asset at the time of maturity? In addition to open market operations and reserve requirements for the central bank, we should note that the central bank could use its guidance advisories to form market expectations and thus affect the investment/saving decision, which in turn will affect economic activity. The impact and effectiveness of central bank guidance, including inflation targets, will be directly proportional to its credibility.

In addition to the implementation of monetary policy, central banks in an Islamic system could take the lead in evolving financial institutions and instruments that facilitate efficient mobilization of savings and allocation of resources consistent with the economic development objectives of the Islamic economy. The central bank, in particular, must initiate and foster the development of primary, secondary, and money markets. Mere adoption of Islamic rules of finance will not necessarily create the impetus for financial and economic development where the shallowness of financial markets and lack of attractive financial instruments have created impediments to the saving–investment nexus and for the process of financial intermediation.

There are reasons to believe that the relationship between financial deepening and real growth of the economy would be strong in an Islamic economy where profit sharing can be expected to have significant positive influence on the saving–investment process. The positive relationship between expansion of financial markets and financial development on one hand and between financial development and economic development on the other necessitates an active participation by the monetary authorities in evolving the economy's financial infrastructure. For example, monetization of transactions in rural areas requires a wider geographical and functional penetration of the banking system. Through provision of such facilities and expansion of financial markets, the central bank can both lower the cost and increase the availability of credit in the economy. Moreover, the prohibition against interest provides natural opportunities for the integration of financial markets. The monetary authorities, through the central bank, can take steps to foster competition between organized and unorganized markets on the basis of profit sharing and rates of return in order to enhance the process of integration.

The extension and enforcement of Islamic regulations concerning contracts and property rights to financial and capital markets is needed to reduce uncertainties arising from the present structure of rights, which tends to discourage private investment. Such actions would include imposition of legal sanctions on irresponsible behavior on the part of agent/entrepreneurs to the extent necessary to reduce moral hazard problems and to encourage lending on the basis of viability and profitability of investment projects rather than solvency, creditworthiness, or collateral strength of entrepreneurs. Uncertainty in contract and property rights combined with heavy costs, at least initially, of project appraisal, evaluation, and monitoring may lead to a significant reduction in investment. In fact, it can be argued that the risk of adoption of an Islamic financial system, particularly in the initial stages, is not lower savings but lower investment, if the Islamic rules regarding contracts and property rights are not enforced. In the absence of legal protection, risk-averse bankers and savers may simply refuse to provide funds on the basis of profit-sharing arrangements. Alternatively, principals and agents may engage in contrived contractual relationships that may be Islamic only in appearance. The enforcement of Islamic rules regarding contracts and property rights would increase public confidence in capital markets, financial institutions, and the process of financial intermediation. Only then will banks and other financial institutions, through their direct involvement in profit sharing with the real sector, become instruments of industrialization and development. This way the whole investment process would add to efficiency, as real entrepreneurs would utilize savings rather than those whose only claim to enterprise is based on ownership of savings. The increase in efficiency will, in turn, increase profits and afford a higher rate of return to savers.

The central bank in the Islamic system can be expected to perform the usual regulation, supervision, and control functions that central banks perform in the conventional financial system. The central bank can also control the banking system through its purchase of equity shares of banks and nonbank financial institutions. The necessity of the central bank's leadership role in initiating and evolving primary, secondary, and money markets has already been discussed. Through performance of these functions and its LoLR role, the central bank can exert greater influence in the financial system. Moreover, opportunities will exist for the central bank to directly invest in the real sector on a profit-sharing basis as well as to take equity positions in joint ventures with other banks. The opportunity for the central bank to buy and sell securities in the financial markets may enable it to influence further financial resource allocation, if that becomes necessary or desirable.

Summary

In the Islamic system, while the objective of monetary policy is broadly the same as that in the conventional system—to promote macroeconomic stability, characterized in the main by price-level stability, near full employment, and a viable balance of payments position, other more broad-based objectives must be kept firmly in sight. These broad-based objectives include a more equitable distribution of resources and income, providing useful employment, improving living standards and the quality of life, and alleviation of poverty, all under the umbrella of social justice. In addition to conducting monetary policy, the central bank in an Islamic system should take the lead in developing financial institutions and instruments that facilitate efficient mobilization of savings and allocation of resources consistent with the economic development objectives. Moreover, the central bank must assume a forceful role in adopting needed regulations and the supervision of banks and investment banks in the system.

There are three major differences in the conduct of monetary policy between the Islamic and the conventional system. In the Islamic system, the instruments of monetary policy are different; there are no interest-bearing debt instruments, and interest-bearing debt is replaced by a variety of equity-based securities (national participation papers, government securities tied to the real rate of return in the economy, etc.) for implementing and conducting open market operations. Moreover, the banking system in the Islamic system is 100% reserve banking as contrasted with fractional reserve banking in the conventional system; this difference eliminates the creation of money by banks and affords the central bank in the Islamic system better monetary control, resulting in a financial system that is more stable and less prone to frequent crises. Finally, monetary policy signals are more potent in the Islamic system because while the objective of both systems is to affect portfolio adjustment in the private sector, in the conventional system, the transmission mechanism of these signals is indirect through the banking system whose objective function is different from that of monetary authorities. Hence, the signals through this transmission mechanism may weaken the signals as they are transmitted through the banking system; namely, the central bank may inject cash into the banking system, but in the final analysis, it is the banks who decide whether to lend to the private sector. In the Islamic system, the transmission mechanism establishes a direct means of signal reception by the private sector through the retail security market. Thus the potency of the signals sent by the monetary authority is strengthened considerably.

Key Terms

1. Central bank
2. Open market operations
3. Discount window
4. Reserve requirement
5. Jawboning or moral suasion
6. Interest rates
7. Central bank
8. Central bank advisories (indications)
9. Central bank credibility
10. Inflation targeting
11. Commercial bank lending
12. Money creation