Principal Economic Agents

In every economic system, four distinct and principal groups interact at the macro level: households, firms, government, and the foreign sector. All macroeconomic activities fall into one of these four groups:

1. Households own the factors of production, such as land, labor, and capital. Households sell these factors to firms, to the government, and to foreigners to earn income. They exchange labor and capital for wages, profits, and rents. Households use their income to pay tax to the government, to consume goods and services, and to save. (In an Islamic economy, there are no debt instruments that carry a fixed and predetermined rate of interest.)
2. Firms employ the factors of production and produce and sell goods (in an Islamic economy, excluding pork and other forbidden foods, alcohol, drugs, and, more generally, any goods that are harmful to humans and to society) and services (excluding interest-bearing financial assets, gambling, sex trade, and any services harmful to humans and to society). Firms' earnings are derived from selling permitted goods and services to households, to other firms, to governments, and to foreigners. In the process firms make investments in their line of activity and earn profits for their stockholders and pay dividends (share their profits) and taxes.
3. Governments collect taxes (and may have other income, such as royalties) to provide government services for households and firms, which include national defense, physical and social infrastructure (including the legal system and regulatory and supervisory administration of markets, businesses, and a number of other institutions), public education, health services (in order to afford equal opportunities for all members of society to succeed in their lives in an Islamic economy), supervision and corrections of excessive income and wealth inequality, and a number of essential social programs. (See Chapter 13.)
4. Foreign countries buy (import) and sell (export) goods and services and make equity investments in other countries or afford investment opportunities.

If an economy has no relations with other countries, it is called a closed economy, while if it trades or borrows from other countries or invests in other countries it is called an open economy. In this chapter, we begin by considering a closed economy, and add the possibility of trade and capital flows later. We begin by discussing these principal concepts: national income, consumption/saving, investment, national income determination, inflation, unemployment, national income and output determination, and trade, capital flows, and open economies.

National Income

A popular index and method for measuring the value of the economic activity is the gross domestic product (GDP). The idea behind GDP is to present aggregate economic activity of all groups (households, firms, government, and foreigners) in a single number for a given period of time. GDP, or more correctly a sister measure called net national product (NNP), essentially measures the largest level of sustainable aggregate consumption (called the “golden rule” in economics) without considering distribution of consumption among the members of society. Some may have vast incomes while others may not even have enough to eat. There are two ways to view GDP. One is as total income of everyone in the economy; and the other is as total expenditures on goods and services. The reason that GDP can show both the economy's income and expenditures is because every transaction in the economy has a buyer and a seller. What consumers spend on goods and services is income for the sellers. As a result, GDP shows the national income and expenditures on goods and services.

There is little correlation of GDP or GDP/capita to human happiness or welfare. The conventional GDP measure falls short on many counts. Externalities are excluded; if pollution from a factory ruins the air we breathe, the pollution is not included as a negative contribution to economic output. This issue is especially important in Islam because the Creator has given the world and all that is in it to all humans of all generations; the rights of all future generations must be protected. In the same vein, conventionally measured GDP does not account for the fact that the production of a depletable natural resource (oil, gas, coal, etc.) is not comparable to the production of goods from a sustainable base (corn, wheat, and other agricultural products, and most other goods) and services. If a country's total output is oil, then with the depletion of oil, its GDP goes to zero. Thus depletable resources have to be accounted for in a different way in GDP, especially for countries that rely heavily on depletable resources and for Muslim countries because such resources receive special treatment because they belong equally to all humans of all generations. This means that depletable resources are a part of the society's stock of capital. Their depletion must be accompanied by creation of alternate capital of equal value. But the conventional measure of GDP values a dollar of oil output the same as a dollar of wheat.

Thus three adjustments must be made to conventional GDP to derive Islamic GDP (IGDP).

1. All prohibited goods and services must be excluded; these include drugs, alcohol, pork, certain fish, gambling, prostitution, all activities that are vulgar, all activities that are based on fixed and predetermined interest rates, and all activities that are deemed illegal by society and cause harm.
2. All negative externalities (pollution, environmental degradation, etc.) must be assessed and subtracted from GDP to get IGDP. (Extensive data collection is required before this can be implemented in the Islamic system.) When these fallouts (negative externalities) are remedied, then improvement can be included in IGDP.
3. The value of the production of any depletable resources cannot just be included in IGDP (like other goods that come from a sustainable base), as is the current practice in conventional GDP derivation. Depletable resources are the Almighty's gifts to humans of all generations. Their depletion cannot be considered contributions to economic output. This issue requires further explanation, as it is very important for assessing the GDP of a number of Muslim countries, especially those that depend heavily on oil and natural gas output.

In economies that do not rely heavily on a depletable resource, such as oil, economic output, or NNP, does not diminish with time but normally can be expected to increase with time. In an oil-based economy, if the income from oil is consumed (and, as is the practice, if oil output is counted as a part of NNP), then NNP declines as oil reserves are depleted. So at least a part of current oil revenues must be saved and invested, domestically or abroad, to even out NNP and avoid a decline in national output in the future.¹ Put differently, the normally or conventionally measured NNP in an oil-producing country diverges from the “theoretically correct” measure of NNP for a country that has no depleting resource such as oil. In a sense the conventionally measured NNP for a depletable resource-based economy usually overstates theoretically correct NNP because at some point in the future, the depletable resource will run out and will no longer contribute to NNP.² The ratio of conventionally measured NNP to “theoretically correct NNP” (for a country whose total output is based on depletable resources) is:

(6.1)

where

1. Y = conventionally measured NNP
2. Y^* = theoretically correct NNP
3. R = real rate of return on investment
4. T = life of oil reserves (in years)

The result is intuitive. The higher the return on investments (i.e., the more compensation made for resource depletion) and the higher the T (i.e., the longer the resource will last at the current rate of extraction), the closer (more comparable) the conventionally measured and theoretically correct NNP. For a country where only a part of its output is based on natural resources:

(6.2)

where

1. P = proportion of national output that is not based on depletable resources

An alternative way of looking at the problem is that depletable resource-based economies need a higher savings rate during the period that the depletable resource is contributing to the national output. The indicated savings rate (to compensate for oil depletion) is lower the higher the life of reserves (in the extreme, no savings from oil revenues are needed if oil revenues were to last forever), the higher the return on investments (if the rate of return were infinite, then a minuscule amount of savings would compensate for oil depletion), the lower the current generation's concern for future generations (if the current generation did not care if future generations starved, then there would be little need for savings), and the lower the share of oil in a country's aggregate NNP. In other words, if a country has many years of oil output, it has less to worry about in comparison to a country whose oil will soon run out. But if society cares for future generations, it is important to save and above all to make investments that count (namely, with a high rate of return) to afford future generations the same benefits that current generations derive from oil. This can be put into a simple equation. For an economy that is based 100% on depletable resources, the required savings rate to compensate for resource depletion is:³

(6.3)

where

1. S = required savings rate
2. S′ = desired post-resource (when the resource is depleted) savings rate
3. R = real rate of return on investment
4. T = life of oil reserves in years

This result is for an economy that derives 100% of its NNP from oil. For such an economy, it is conceivable that today's indicated savings rate could even be negative. The reason for this seemingly perverse result is essentially this: Imagine a region or country that has many years of oil reserves left at current depletion rates (such as Abu Dhabi, a part of the United Arab Emirates) and wants a modest savings rate when oil is projected to run out. Today it can afford even to dissave (negative saving). This result is clearly the exception and is not indicated when we account for the fact that, in reality for most countries, there is a significant percentage of non-oil NNP (see the adjusted equation next) and that countries want to have a high savings rate when oil runs out.

For an economy that is not 100% resource based, the equation is:

(6.4)

These three changes must be made to GDP to derive IGDP; the only word of caution is the needed data for calculating negative externalities. But there is more. The GDP or IGDP index would be indifferent to two very different situations: one where nearly all of the national income accrues to one person and the rest of society lives in poverty, and the other where everyone had at least comparable incomes. In the GDP calculation, it is assumed that humans live to acquire material wealth and that the higher the GDP, the better off they are. In other words, GDP is the indicator of choice and captures everything that matters. In an Islamic economic system, we would ideally like to have a measure of an Islamic gross social product of goods and services (IGSP) as a measure of an economy's aggregate output of goods and services. But this may be technically beyond reach and also may present other problems in devising macroeconomic policies, as GDP is the focus of policies that governments adopt. We have very little data on all dimensions of individual happiness and well-being and on the interaction and impact of individual circumstances on society. Moreover, items such as income distribution and poverty cannot simply be added to the value of output of goods and services; GDP is a dollar figure whereas income distribution is some sort of an index.

Fundamentally, well-being means different things to different observers. When well-being is defined as spiritual and humanitarian goals as well as material goals, other values such as justice, brotherhood, peace, happiness, solidarity, importance of family, and so forth intentionally come into play. Umar Chapra writes:

One of the tests for the realization of these goals may be the extent to which social equality, need-fulfillment of all, full employment, equitable distribution of income and wealth, and economic stability have been attained without heavy debt-servicing burden, high rates of inflation, undue depletion of nonrenewable resources, or damage to the ecosystem in a way that endangers life on earth. Another test may be the realization of family and social solidarity, which would become reflected in the mutual care of members of the society for each other, particularly the children, the aged, the sick, and the vulnerable, and absence, or at least minimization, of broken families, juvenile delinquency, crime, and social unrest.⁴

In this sense, the scope of the Islamic economics would be wider than in conventional economics and would include social, political, environmental, and historical issues. In the other words, well-being in this approach needs a more comprehensive framework than satisfying self-interest. Thus, different visions and definitions for well-being make for different approaches toward policies, mechanisms, and methods that are used in an economic system.

However, none of the predominant worldviews is either totally materialistic or totally humanitarian and spiritual. The emphasis they put on material versus spiritual goals is significantly different. The different level of emphasis on each of those goals might result in different economic policies. Moreover, in conventional theory, well-being is treated as a positive rather than a normative concept. This means that it is value neutral and is defined in terms of unrestricted individual freedom. Neglect of material needs or spiritual needs may destroy the true meaning of well-being and lead to undesirable results. The Islamic worldview is not value neutral, secularist, and materialist. Some concepts are at the heart of the Islamic economics. It insists on moral values, human brotherhood, and socioeconomic justice. It relies on the role values play, market, family, society, and state to provide for the well-being of all. The core of Islamic belief is that the universe and everything in it has been created by the One God, and all humans are equal brothers and sisters to each other. There is no superiority because of race, sex, nationality, wealth, or power. Also, life in this world is ephemeral, and the ultimate destination is the Hereafter. Allah (swt) will judge who has fulfilled their obligations toward others.

As we have discussed earlier, there is little evidence to connect GDP to happiness and well-being.⁵ A number of studies recommend including at least the quality of life, social progress, and sustainable development in a reformulated index of national output. Although a general agreement has not emerged among nations for a better criterion to measure well-being, the Organization of the Islamic Conference signed the Istanbul Declaration in 2007, which emphasizes the need to go beyond GDP, specifically to incorporate the spiritual needs of humans. But little progress has been made in this regard. Thus, the best that can be done is to develop the data for IGDP as modified from GDP and make the social issues (such as eradication of poverty, a more equal distribution of income, etc.) an absolute constraint on economic management.

GDP or IGDP is determined by the quantity of inputs that are called factors of production and by the ability to convert these inputs to outputs, which is commonly called the production function. Main production factors are labor, including human capital, and capital, including technology embodied in machines. Labor is the time people spend working, and capital is the machinery and equipment workers use. The production function describes how much output can be produced by a given amount of capital and labor. The factors of production and the production function determine the total output of goods and services and also represent national income. What households earn in wages and rents go into the national income. What firms pay for wages and rents are called factor prices. Hence, the factor price for workers is wages; for owners of capital, it is rent/real rate of return. The demand for each factor affects its price. Factor prices are one of the important determinants of income distribution. In sum, a firm's output needs two inputs: labor and capital. The production function can be written as:

(6.5)

where

1. Y = production or firm's output
2. K = amount of capital
3. L = amount of labor

The firm sells outputs at price (P), pays wages (W) to workers, and pays rents (R) to capital's owners in a profit-loss-sharing mode of partnership. Households own labor and capital and are paid by firms for these inputs. The assumption that households own the capital input is a simplification, but it does not undermine our results because in the real world, firms own capital and households own the firms.

A couple of questions immediately come to mind: How much do firms produce in an economy? Who gets the income from production? How much of the income will go to workers and how much will go to capital owners? To answer these questions, initially we assume that firms face competition from other firms in the market; this means that one firm cannot set market prices as prices rise and fall in the market because there are many sellers. Also, a firm cannot set wage or rental rates for factors of production because households can sell their labor and capital to other firms that offer higher wages or rents.

We further assume that firms maximize their profits. The profit for firms can be defined as:

(6.6)

Replace Y with F (K, L):

This equation shows that profit depends on the price and quantity of the output, factor prices, W and R, and the quantity of factors of production, L and K, used. In a perfectly competitive market, firms cannot determine price (P) and are in fact price takers so that firms have to choose the combination of capital and labor to maximize their profits. The productivities of the factors of production determine this combination.

The marginal product of labor and marginal product of capital explain the productivity of the capital and labor. Marginal product of labor (MPL) is defined as the additional amount of output that is gained as the result of employing one more unit of labor. If we assume the amount of capital is constant, adding one more unit of labor increases the firm's revenue by P × MPL, where P is the price of output and MPL is the extra output of labor by using one more unit of labor. Change in cost for adding one more unit of labor is the wage (W) that firms pay. The next equation shows the change in profit for the firm (note that the amount of capital used has not changed):

(6.7)

According to the equation, when P × MPL exceeds the wage rate, the addition of an extra unit of labor is profitable. Therefore, a firm continues to employ labor until P × MPL equals what is paid as wage:

(6.8)

We can write this equation in another format:

(6.9)

W/P is called real wage and shows that labor is paid in units of production rather than with money.

Similarly, marginal product of capital (MPK) is an additional amount of output as the result of employing one more unit of capital while keeping the amount of labor employed a constant. If we assume the amount of labor is constant, adding one more unit of capital results in an increase of the firm's revenue by P × MPK, where P is the price of output and MPK is the additional output. Change in cost for adding one more capital is the rent (R) that firms pay. This equation shows the change in the firm's profit:

(6.10)

Accordingly, when P × MPK exceeds the rent, adding an extra unit of capital is profitable. Therefore, the firm continues to rent capital until P × MPK equals the rental rate on capital: P × MPK = R.

We can write this equation in another format as:

(6.11)

R/P is called real rental price of capital and shows what capital is paid in units of production rather than in money.

In sum, in maximizing profits, a competitive firm hires each factor of production until the factor's marginal product is equal to the real factor price. In other words, productivity of capital and labor (marginal products of capital and labor) determine the proportion of the economy's income that go to labor and capital.

While Islam endorses the market system just described (for affording incentives and enhancing efficiency), firms cannot simply have as their sole objective the maximizing of profits. They must provide good working conditions, supplement healthcare provisions, and pay a living wage to all workers. Moreover, there are postmarket considerations for individuals. After receiving profits and incomes, they must make religious contributions in the form of zakat and khums (a flat income tax), pay taxes to finance needed public expenditures (including social infrastructure, to correct for unequal opportunities and poverty that continue to exist), and make further contributions to correct for large inequalities of wealth and income.

Consumption, Savings, Investment, and National Income Determination

Up to now, GDP has been discussed as the total output of goods and services and IGDP as the same total with three major adjustments for Islamic morality considerations and concern for the welfare of future generations. GDP/IGDP can be also interpreted as the allocation of goods and services among different uses. GDP (from here on, we use “GDP” to mean IGDP as well, unless stated otherwise) is divided into four main categories: consumption (C), investment (I), government purchases (G), and net exports (NX). GDP or total output is equal to sum of these four parts:

(6.12)

Each unit of GDP, for example, each dollar, falls into one of these categories.

Consumption is the amount of goods and services purchased by households. Consumption normally is further divided into three subgroups: nondurable goods, durable goods, and services. Nondurables goods are goods that deplete after a short time, such as food and clothing. Durable goods are goods that last for a long time, such as cars and refrigerators. Services are produced by individuals or firms, such as teaching, haircuts, and financial products.

Investments are goods and services that are purchased to produce future output of goods and services. Investments are made in order to increase future output and provide a higher standard of living in the future. There are three types of investment spending. A person makes a residential investment, which includes a new house to live in or rent to others. Businesses make a business fixed investment, which includes the equipment and structures used in production, and they also place some goods in storage as an inventory investment, which includes materials, semiprepared goods, and finished goods.

Government purchases are goods and services acquired by the government. For example, governments buy guns, build roads and bridges, build schools, and hire teachers. Governments also provide a number of social programs, such as healthcare especially for the less fortunate, food for the poor, or payments to the elderly in the form of income transfers and education.

Net exports depend on trading with other countries. Net exports are exports minus imports. Exports are the value of goods and services sold to other countries. Imports are the value of goods and services that a country buys from the rest of the world.

The first three are components in a closed economy, and the fourth belongs to an open economy (an economy that has trade with other countries). Here, we assume a closed economy. Thus, the NX is zero and three components constitute GDP:

(6.13)

As mentioned, households consume some of the economy's output; firms and households use some output for investment; and the government buys some outputs for its programs.

Households receive payments from firms for labor and capital and then pay a percentage of this as taxes to the government (to finance government expenditures). From their income, households pay zakat and khums (and land taxes [kharaj]). If the amount of these Islamic payments is insufficient to meet social needs and if income and wealth disparities are still too great, households are encouraged to pay more. If conditions are still unacceptable then the government may impose further taxes to meet social needs. What households have as income (after all of these various postmarket corrections) could be correctly labeled as Islamic disposable income in an Islamic economic system; households save a portion of this and consume the rest. The level of disposable income is an important determinant of consumption. A higher level of disposable income results in a higher level of consumption. In an Islamic system, the consumption function can be written:

(6.14)

where

1. T = taxes
2. IP = direct Islamic-mandated payments (which become disposable income for others if completely passed through)

Thus for the economy as a whole, IP is akin to a deduction from the income of the well-to-do and income for those that are less fortunate. Since consumption is usually a substantial part of the GDP, macroeconomists invariably pay more attention to this part of the GDP. But it should be again emphasized that people must avoid ostentatious lifestyles and large disparities in lifestyles of the rich and the poor.

Government is the second component of the aggregate demand for goods and services. The government purchases goods and services for different purposes. For example, government buys guns, builds schools, and hires teachers. Programs such as welfare for the poor or payments to elderly persons that transfer income and are not exchanged for goods and services do not count as government purchases. Government income for most countries is largely from taxes. When purchases by governments and taxes are equal, G = T, a government has a balanced budget. If government's income or taxes are less than its expenditures, it incurs a budget deficit. If income exceeds expenditures, the budget is in surplus. Persistent budget deficits translate into a growing national debt. In a number of Muslim countries, nearly all of the government income comes from the depletion and sale of oil and natural gas reserves (something that cannot last forever).

The third component of output is investment. Investment is the most volatile component of GDP (in part because of the volatility of interest rates and economic activity in the conventional economic system). Firms and households purchase investment goods; for example, households buy new houses, and firms buy new machinery and equipment to replace old machinery and equipment. Also, households save their money in a number of ways, including stocks, other forms of investment partnerships, cash, and real estate that is used productively. (In the Islamic system, land not used productively for a period of time may be acquired by others.) Firms can use their own savings and raise money from investors (savers) to buy new investment goods. The quantity of investment goods demanded by firms is in part dependent on the demand for the output produced by the new investment, business expectations about economic conditions and the general business outlook, the real rate of return in the economy, and, more generally, the cost of capital (the interest rate in the conventional system) and taxes that affect the cost of financing. The larger the economy, the brighter the business expectations. The higher the real rates of return adjusted for investment tax incentives, the larger investment is. The amount of businesses borrowing from financial markets depends on the expected profitability of projects. When a project is profitable, earnings from it exceed the cost of money. As a result, in the Islamic system, when households want a larger share of the profits, fewer investments are generally profitable, and the demand for investment goods falls. The investment is what remains from the output after consumption by households and government expenditures:

(6.15)

Y − C −G is also called national savings or simply savings (S). National savings is divided into two parts: private savings (output minus tax and consumption) and public savings. Private savings = Y − C − T (IP is a wash because it is a deduction from income for some households and an addition to income for others) and public savings (taxes minus government purchases) = T − G.

As the result, total savings by definition would be equal to investment:

(6.16)

Equation 6.16 shows that national savings depends on national income Y, consumption, and the variables G, T, and IP (to the extent that different income groups would have different savings rates, IP affects national savings). By changing taxes and government expenditures, government fiscal policy can impact savings and investment. Consider the increase in government spending. When the total output is fixed and disposable income, Y − T, is unchanged, the rise in government spending must be met by an equal decrease in investment. Now consider a reduction in taxes; it increases disposable income and consumption. In this case, when government purchases are fixed and the economy's output is fixed by factors of production, then an increase in consumption must be met by an equal decrease in investment.

Household consumption decisions impact the economy in both the short run and the long run. The way that households decide between consuming and saving is a microeconomic question because it is an evaluation about individual decision makers, but in the aggregate, the combined behavior of consumers has important macroeconomic consequences. We explained earlier how consumption relates to disposable income: C = C(Y − T). This approximation gives us a simple model to analyze consumer behavior in the short and the long run, but it is too simple to give us a complete explanation for consumer behavior. Since consumption is the largest component of aggregate demand and GDP, the consumption function has received the most attention and should be further explained. There are three prominent theories of consumption.

John Maynard Keynes developed a theory of consumption that plays a central role in his theory of economic fluctuation, which is discussed later. He had three assumptions for the consumption function. First and most important, he postulated that an increase in income would result in an increase in consumption, but not by as much as the increase in income. Thus when a person earns extra income, he or she spends some of it and saves some of it. Keynes defined the marginal propensity to consume (MPC), which is the additional amount of consumption as the result of an additional unit of income. He assumed MPC is between zero and 1 because people consume some part of their additional income and save the remaining part. Second, Keynes explained that the ratio of consumption to income, called the average propensity to consume, falls when income rises. He believed that saving is a luxury so that rich save a higher part of their income than the poor. Third, Keynes believed that income is the main determinant of consumption, and the interest rate (real rate of return in an Islamic economy) does not have an important role in consumption. (Classical economic theory taught that higher interest rates encourage people to save more and consume less.)

The Keynesian consumption function could not explain a number of observed facts. Keynes assumed that as income grew over the time, households would consume a smaller and smaller part of their income. As a result, there would be inadequate demand for goods and services, resulting in recession and unemployment. After the end of World War II, as incomes increased, these higher incomes did not lead to large increases in the rate of saving. In other words, Keynes's assumption that the average propensity to consume would fall with rising income did not hold. A second anomaly emerged as Simon Kuznets discovered that the ratio of consumption to income was quite stable over a long period of time. Thus, Keynes's assumption that the average propensity to consume would fall with rising income did not hold. In fact, economists believed that there were two consumption functions. For the short run, the Keynesian consumption function seemed to work pretty well, but for the long run, the average propensity to consume appeared to be a constant. Different behavior between short-run and long-run consumption functions made it necessary to explain why the consumption decisions were different.

The Keynesian consumption function relates current consumption to current income. Other economists hypothesized that the consumption decision was dependent on both current and expected future income. More consumption today affects the amount consumers can consume in the future. Irving Fisher introduced a model that determines how the constraints consumers face, the preferences that they have, and the interaction of constraints and preferences affect choices about consumption and saving. Keynes postulated that a person's consumption is largely related to current income; Fisher's model says that consumption is based on the income that the consumer expects over his or her entire life. Modigliani and Friedman separately tried to address this issue and provide the other two major theories of consumption.

Franco Modigliani argued that income varies over a person's lifetime and saving allows consumers to smooth out their consumption pattern by saving income during the high earning years for the low earning and retirement years. Thus the consumption decision today is based on wealth and current and future earnings in order to smooth out consumption over a lifetime. The shape of consumer behavior is called the life-cycle hypothesis; individuals save during years of high income and dissave during retirement. Retirement is one of the important reasons for variations in consumption. People save and invest during their working years to maintain the level of consumption during retirement. Consider a person who lives for another A years. This consumer has initial wealth (W) and expects to earn income (Y) until retirement (R) years from now. We want to know how much he would consume during a lifetime to smooth his consumption. Equation 6.17 shows the smoothed path of consumption for him:

(6.17)

Equation 6.18 tells us he consumes his wealth, W, and his lifetime earnings, RY, over A years. Also, we can write this equation as shown next:

(6.18)

Replace 1/A with α and R/A with β in the previous equation and the consumption function can be restated:

(6.19)

where

1. α = marginal propensity to consume out of wealth
2. β = marginal propensity to consume out of income

Milton Friedman suggested the permanent-income hypothesis as an alternative to Modigliani's model. He used Irvin Fisher's theory that argues consumption does not depend on current income alone. Friedman emphasized that current income, Y, is made up of two parts: permanent income, Y^P, and transitory income, Y^T. Permanent income is the part of income that people expect to continue into the future. Transitory income is the part that people do not expect to continue into the future. In the other words:

(6.20)

Friedman believed that consumption would depend on permanent income, not transitory income. He reasoned that since consumers use savings and borrowing to smooth consumption during their lifetime, they would not spend all of their transitory income. Friedman concluded that the consumption function is approximately a function of permanent income:

(6.21)

where

1. α = a constant that determines the fraction of permanent income consumed

Fahim Khan argues that (theoretically) devout Muslims in an Islamic economy would make two types of consumption decisions (as opposed to one in all conventional economic systems): (1) to meet their own household needs, and (2) to meet the needs of others as mandated by the Islamic faith, with the allocation between these a matter of personal choice. Khan goes on to add:

Without specifying how much of one's income should be spent for others in the way of Allah, great emphasis has been placed on such spendings. The more one spends for others (for the sake of Allah) the better for him in this world and the hereafter.⁶

In all decisions, Khan argues that the Muslim consumer must be rational (learn and acquire the trait) and that this differs from the case of conventional economics, where it is assumed. And importantly, Khan adds that Muslims should save for future consumption, not by hoarding but by investing (along the lines of Modigliani). He sums up a Muslim's consumption behavior in this way:

1. A Muslim consumer's total spending can be classified into the following major categories:
   1. Spending to achieve satisfaction in this world (E1). This includes (i) present (immediate) consumption (let us denote it by C1) and (ii) savings/investment for consumption in future (let us denote it by S1).
   2. Spending for others with a view to earn reward in the hereafter (E2). This includes (i) what is immediately consumed by the recipients (let this be C2) and (ii) what is invested for social purposes or community benefits or what is saved by the recipients for their own investment (S2).
2. The consumption basket of a Muslim is likely to be smaller than that of a secular consumer as it includes only permissible things and excludes prohibited things.
3. The allocation between E1 and E2 and between C1 and S1 within E1 or between C2 and S2 within E2 has been left to rational consumer behavior which should be dominated by God-consciousness.
4. The degree of God-consciousness is an essential parameter in determining consumer behavior of a Muslim.
5. The only limit that has been specified is the minimum limit of E2 for those who are obliged to make these types of spending.
6. A Muslim is allowed to save, a major part of which will have to be invested in order to earn at least a return that would prevent his savings from being depleted by zakah.⁷

In sum, Keynes proposed that consumption is a function of current income. Other conventional economists argued that consumers take into account their wealth and also look ahead to their expected future income, thus requiring a more complex model to explain consumption. Modigliani and Friedman suggested adding wealth and expected income to this function. Economists continue to argue over the theory of consumption. For example, some argue about the importance of the interest rate, and others focus on psychological effects. Consumption function seems to remain important in economists' debates because it has the dominant role in national income (a large share of aggregate demand, especially in the United States) and in economic fluctuations. In Islam, the major differences from the Modigliani hypothesis are that Muslims are required to spend in the Way of Allah (swt) for the less fortunate and for society, to limit their wants and live modestly, and to invest (not hoard) wealth to foster prosperity. But we must emphasize that while the Modigliani hypothesis is generally supported by data in most countries, the Islamic model (which also includes spending for the welfare of others) does not appear to be supported, even in Muslim countries. Essentially, Muslims do not appear to consume as recommended by the Quran and the Sunnah; they may be Muslims, but they behave as conventional consumers.

National Income and Output Determination

Most economists believe that the time horizon is an important dimension when it comes to analyzing macroeconomic models. They divide the time horizon into the short run and the long run because they believe economies behave differently in each horizon. The main point here is that in the long run, prices are flexible and can respond to change in supply and demand, but in the short run, many prices are sticky. Flexible prices are an important assumption of the classical economic theory. The theory assumes the prices adjust to ensure that the quantity of output demanded equals the quantity of output supplied; however, the economy behaves differently when the prices are sticky. In the short run, the output of the economy also depends on the economy's demand for goods and services, and demand depends on many other factors, such as monetary and fiscal conditions and policies.

Aggregate demand depends on monetary policy (quantity of money and real rate of return in the economy), fiscal policy (taxes and public expenditures), expectations, business confidence, foreign incomes, asset values, and demographic factors. Aggregate supply depends on the economy's potential output or its capacity to produce (especially in the long run), and on wage price relationships. (Price and wage stickiness give short-run aggregate supply an upward slope, but the long-run supply is a vertical line as all costs and prices adjust by roughly the same amount.)

In the short run, the interaction of aggregate demand and aggregate supply determines the economy's price level and the quantity of national output, or GDP. Since the firms that supply goods and services face flexible prices in the long run but sticky prices in the short run, the aggregate supply relations depend on the time horizon. Long-run aggregate supply (output), according to classical theory, does not depend on the price level (a vertical function). This long-run level of output, Y, is called full-employment or the natural level of output. This would be the level of output if the economy's resources are fully employed or unemployment is at the natural rate.

The state has a crucial role in ensuring economic activity and prosperity. As the world witnessed during the Great Depression and more recently in the Great Recession, there is no reason to believe that the economy will be operating at full employment (the natural rate, restated as NAIRU, the nonaccelerating rate of unemployment, by Modigliani and Papademos).⁸ In fact, it is highly unlikely that the economy will be humming along at NAIRU for any length of time. There will be periods when aggregate demand is too low (aggregate supply is high) and others when it is too high (supply is low), requiring government intervention to nudge the economy back to the NAIRU level of activity. Stabilization policies—monetary and fiscal—are crucial in moderating economic fluctuations and in maintaining employment, something that is crucial to prevent economic hardships for families and for society in general. But government's role in stabilization goes beyond monetary and fiscal policies to include industrial policies, trade policy, exchange rate policy, and income policies. While government can adopt policies to support economic activity and nudge the economy toward its NAIRU level, it may have as important a role to enhance growth.

In the short run, most prices are stuck at predetermined levels. At these prices, firms want to sell as much as their customers are willing to buy, and they hire enough labor to answer the customers' needs. The fall in aggregate demand in the long run does not impact output (remember the classical theory) and adjustment is made by rising price levels. In the short run (prices are sticky), falling aggregate demand is compensated for by falling output. In sum, over the long run, prices are flexible, aggregate supply is vertical (output is fixed), and changes in aggregate demand affect only the price level, not output. Over a short period of time, prices are sticky, the aggregate supply has a slope (prices are fixed), and changes in aggregate demand affect the output of the economy. Since the prices are not fully flexible in the short run, reduction in aggregate demand reduces output. After falling aggregate demand, firms are stuck with prices that are too high. As a result, firms sell less of their product so they reduce production and lay off workers. This is how an economy enters a recession. Monetary policy gives an important tool to policy makers to control aggregate demand. By reducing and increasing the velocity of money, central banks can play a vital role in aggregate demand.

Economists have developed different models over the years to explain the operation of the economy and different policies to avoid shocks and to stabilize economic conditions. What we have discussed so far regarding the determination of national income is largely the position of the classical economic theory. According to this theory, national income depends on factor supplies and available technology (potential output). The classical view has two main assumptions. First, it is assumed that supply creates its own demand in a macroeconomy. Thus someone will buy everything that is produced in the economy. Hence, the economy operates at full employment and production. The second assumption of the classical theory is that wages and prices are flexible, and they will adjust to ensure that the economy operates at full employment.

During the 1930s, many parts of the world experienced vast unemployment and significantly reduced incomes, namely the Great Depression. Since neither the factors of production nor technology had changed, economists questioned the capability of classical theory to explain the Great Depression. Hence, many economists believed that a new explanation was needed for the global economic meltdown. The British economist John Maynard Keynes proposed a new model as an alternative to the classical theory; it was called Keynesian economics. Keynes criticized classical theory for assuming that aggregate supply, including labor, capital, and technology, determine national income. He suggested that low aggregate demand is the reason for the low income and high unemployment. Keynes proposed that the economy's total income in the short run is determined by spending plans of households, government, and businesses. The logic of his statement is that when more people want to spend money on goods and services, firms provide more goods and services. In turn, to provide more goods and services, firms will have to hire more workers. As a result, Keynes believed that the problem during recessions and depressions is related to an inadequate level of spending or insufficient aggregate demand. To better understand this issue, we define actual and planned expenditures. Actual expenditures are the amount households, firms, and the government spend on goods and services, namely, GDP. Planned expenditures are the amount households, firms, and the government would like to spend on goods and services. The difference between actual and planned expenditures might come from unplanned inventory investment by firms. When firms sell less of their product than they planned, their stock of inventories rises. When firms sell more than they planned, the stock of inventories falls. Since these unplanned changes in inventories are taken into account as investment spending by firms, actual expenditures can be either above or below planned expenditures. Denote planned expenditures as PE and rewrite the output equation for a closed economy:

(6.22)

Equation 6.22 shows planned expenditures as the sum of consumption, C, planned investment, I, and government expenditures, G. Recall the consumption function, C = C(Y − T), and replace it in the last equation:

(6.23)

Equation 6.23 determines that planned expenditures are related to the level of income, Y, the level of planned investment, I, and fiscal policy variables, G and T. (Again, it should be noted that the Islamic mandated payments, IP, are transfer payments between consumers and are omitted but their size does affect aggregate consumption as different income groups have different MPC.) In the Keynesian model, the economy is in equilibrium when actual expenditures are equal to planned expenditures, that is, the same as when planned savings equals planned investment. (By definition, actual savings always equals actual investment.):

(6.24)

If output is greater than the equilibrium level, planned expenditures are less than production; hence, firms are selling less than what they are producing. In other words, firms are adding goods to their inventories. This unplanned rise in inventories causes firms to lay off more workers and reduce production, resulting in lower GDP and a higher unemployment rate. The process of falling output and rising unemployment will continue until Y falls to the equilibrium point. Similarly, if output is below the equilibrium point, planned expenditures are above production so that firms are shedding inventories. A lower level of inventories induces firms to increase employment and increase production to the point when Y equals planned expenditures. In sum, the Keynesian model determines how output, Y, is determined for a given level of planned investment and fiscal policy variables, G and T.

Having explained how planned investment can influence expenditures, we now examine briefly how fiscal policy affects the economy. For example, if we assume that government purchases rise by ΔG, it leads to an increase in income, ΔY. The change in income is bigger than change in government purchases. The ratio of ΔY/ΔG is called government-purchase multiplier. This ratio tells us how much income rises as the result of one unit increase in government purchases. This fiscal policy measure in turn has a multiplier effect on income because higher income leads to higher consumption according to the consumption function C = C(Y − T). Hence, an increase in government purchases raises income and also raises consumption. The rise in consumption in turn also raises income, and this process will continue. The government can also decrease taxes. A reduction in taxes raises disposable income, Y − T. Hence, planned expenditures will be higher at any level of income. Therefore, in contrast to the classical theory that assumes that the economy can adjust by itself and that government intervention (stabilization policies) is useless or even counterproductive, the Keynesian school believes that government intervention in the short run can adjust the spending gap that is responsible for recession and unemployment. (See Figure 6.1.) The equilibrium level of national output, E, given by the level of C, I, and G, may entail a significant level of unemployment and unemployed resources. Here is when discretionary fiscal and monetary policy come into play—increasing C, I, or G. This we take up in Chapters 12 and 13.

The Chicago School, pioneered by Milton Friedman, introduced the monetarist view. Proponents of the monetarist view challenge the Keynesian fiscal policy prescriptions. They believe that fiscal policy is ineffective, all government stabilization efforts are counterproductive, and a simple rule for the growth of money in the economy is the best form of monetary policy. Chapter 11 presents a more detailed discussion of monetary policy and its workings in an Islamic system.

Inflation

Economists call the increase in prices inflation. Inflation is an increase in the average level of prices. An important source of inflation is too much demand chasing too few goods. As money in circulation impacts demand for goods and services, understanding money and its role in inflation plays a vital role in understanding inflation.

The quantity of money available in an economy is the money supply. The printing of money is under the control of government. Government's control of the money supply is called monetary policy. Usually a partially independent institution called a central bank is in charge of monetary policy. For example, in the United States, the central bank is called the Federal Reserve (Fed). The Fed controls the supply of money through the sale and purchase of government bonds. The Fed buys government bonds when it wants to increase the supply of money; the money goes to banks (in turn to the public through lending) from the Fed in exchange for government bonds. The Fed sells government bonds when it wants to decrease the supply of money; the money returns from banks to the Fed.

The quantity theory of money shows the relation of the quantity of money to prices and income. People need money to buy goods and services. The more money needed for buying results in more money being held for transaction purposes. The relationship between transactions and the quantity of money is:

(6.25)

where

1. M = money
2. V = velocity
3. P = price
4. T = transactions

On the right-hand side of equation 6.25, T is the total number of transactions in a period of time (e.g., a year). In other words, T shows the number of times in a year that goods or services are exchanged for money. P is the number of units of money exchanged (e.g., dollars). As a result, PT is the number of dollars exchanged in a year. On the left-hand side of the equation, M is the quantity of money, and V is the transaction velocity of money. V measures the number of times that a unit of money changes hands in a given period of time. For example, if the quantity of money (M) increases and the velocity of money (V) remains constant, then price (P) or the number of transactions (T) has to rise.

The problem with the quantity equation is that the number of transactions is difficult to measure. To solve the problem, the total output of the economy, Y, could replace the number of transactions; this would indicate that when an economy produces more, we could expect that more goods and services are bought and sold. Therefore, equation 6.25 can be written as:

(6.26)

where

1. Y = output of the economy

If we add an assumption that the velocity of money, V, is constant, the quantity equation becomes a useful theory that shows the effect of money supply on output. This theory is called the quantity theory of money. Recalling that Y represents GDP, we also call Y real GDP. When the price level is introduced for accounting GDP, Y is called nominal GDP, which shows the dollar value of the economy's output. As a result, PY shows nominal GDP, and the quantity of money determines the nominal GDP.

Recalling that inflation is the percentage change in the price level, the quantity theory of money can be treated as one theory for explaining inflation. Rewrite the quantity equation in this form:

(6.27)

If we assume that the change in the velocity of money or demand for money is zero, then, if the percentage change of the quantity of money changes, the percentage change in the price level, P, or the rate of inflation or the percentage in output, Y, must also change. The change in output depends on growth in the factors of production and on technological progress. As a result, this theory explains that the growth in money supply determines the rate of inflation. Thus, if the central bank increases the money supply rapidly, the price level will rise rapidly; in other words, inflation is seen as a purely monetary phenomenon.

The question is often raised if money is lent without riba (interest), should the amount of the loan be adjusted for any decrease or increase in the value of money (real purchasing power) over the period of the loan. The indexation of financial obligation refers to an adjustment in value over a period of time to compensate for the change in value due to inflationary or deflationary pressures. Indexing wages to inflation is a very common practice, but indexing investments or financial obligations is also growing quickly in conventional financial markets. In the case of financial assets, inflation-linked securities link the returns to the consumer prices index or to the cost of living index. The adjustments are often in the form of ex post facto adjustments, and the objective is to guarantee a return equal to the real interest rate instead of the nominal interest rate.

Indexation is justifiable in the eyes of Shariah for wages, salaries and pensions, social security payments, and so on, but Shariah does not support indexation of financial assets. Some scholars argue that Islam's notion of justice is a ground for compensation when lending without al-riba; others argue that the prohibition is absolute and any compensation or indexation would amount to interest. Opponents of any adjustments base their arguments on moral, legal, economic, and financial grounds. Some of the arguments against indexation are based on finding solutions to the sources of fiscal imbalance and price instability rather than making any adjustments through indexation. Common arguments against indexations are briefly discussed here.

First, it is argued that the verses of Quran (2:275) clearly protect only the principal amount of the loan and consider anything in excess of it as al-riba. It is understood that this prohibition covers all transactions that may make any adjustments similar to al-riba, such as deferred exchange of currency, devaluation or revaluation, and change in the unit of currency at the time of repayment of loans. Since lending of money is a currency transaction that is treated as similar to exchange of a commodity, any compensation for the fall in the value of money is not justifiable.

Second, Muslim scholars also argue that by virtue of inflation in the economy, an investor's or lender's purchasing power would be at stake irrespective of whether money is lent as a loan on a non-al-riba basis or is invested in a return-bearing security. In either case, the net loss to the lender is a real interest rate or real return. Even if money was not lent but was kept for consumption purposes, the same loss of purchasing power will occur. Therefore, it seems unreasonable to expect the borrower to bear all the loss, a loss that the lender would likely incur even if he or she had not made the loan.

Third, it is argued that even if some form of indexation is allowed, it may not be in consonance with the notion of justice and therefore may not serve its intended purpose. While it is recognized that inflation is the loss of purchasing power and indexation is a compensation for such a loss, the problem is how to clearly identify and hold a certain party responsible for its share. There are several contributing factors leading to inflation, and the contributing magnitude of each factor and party cannot be determined. Therefore, it is unjust to ask one party to take the entire burden while others are burden-free. For example, if only the borrower is asked to compensate for the loss, which was caused by factors beyond the borrower's control (e.g., irresponsible policies of the government), it would imply that a person who is not responsible for inflicting the loss is made to compensate for it while the responsible party is not held responsible.

Fourth, some scholars have also discussed the practice of indexation by arguing that there is no perfect index that can fully capture the loss of the value. The constituents of the index representing the cost of living may not serve as a good proxy for the loss in purchasing power. Also, the cost of living index represents the consumption habits of an average person in an economy. Since the cost of living may differ from region to region and from city to city, it is not possible to measure it accurately. This inaccuracy can lead to an unjustified transfer of wealth from the borrower to the lender or vice versa. Similarly, inflation indices are based on a lag and therefore are not readily available to be used in daily financial transactions. All these factors make indexation less practical and prone to biases, which may open a back door for unjustified charges.

Finally, Shariah scholars and economists raise the issue that indexation is not the answer. Rather, price stability and fiscal discipline are to be achieved to combat inflation. In this respect, the role of the state in causing inflation leading to disequilibrium in the economy should receive serious attention. Some economists argue that it is the responsibility of an Islamic state to take effective steps to check inflation in order to minimize the depreciation in the value of money. When the government policies are the source of inflation, the government should compensate the borrower.

Irrespective of the causes and sources of inflation, indexation is not accepted by scholars; however, other remedies have been suggested. For example, if the lender and the borrowers are concerned about inflation, then the loan can be denominated in terms of a commodity (e.g., gold). The lender can lend a certain quantity of gold to the borrower who is obligated to return the same quantity at the expiry of the loan. It is also pointed out that the partnership and profit-and-loss-sharing instruments of the Islamic economic system provide a built-in compensation for inflation because the profit is shared in the agreed ratio whereas the losses are borne in the ratio of respective capitals.

Unemployment

Unemployment is a key macroeconomic indicator because it affects individuals and families directly and sometimes severely. Unemployment, especially for an extended period of time, means a lower standard of living and emotional hardship for most individuals and families. It also has a highly deleterious effect on the social fabric of society. In Islam, having a job and working hard (for those who physically can) is an important part of a Muslim's economic and social obligation. Thus, being close to the natural rate of employment (or full employment) must be an overriding goal of public economic policy. Thus, the provision of jobs becomes crucial.

If L is the labor force, E is the number of those employed, and U is the number of the unemployed, then the labor force is the sum of the employed and the unemployed:

(6.28)

The unemployment rate is the ratio of unemployment to the labor force, U/L.

There are two types of unemployment: frictional unemployment and structural unemployment. Frictional unemployment is a result of the time invariably needed for workers to move from one job to another. Workers have different skills and preferences, and jobs have different skill requirements. Thus the provision of education and skills training becomes an important policy in an Islamic society. Moreover, the information about vacancies is not easily available, and labor mobility is not instantaneous. Therefore, matching workers to jobs consumes time and effort. Some frictional unemployment is thus inevitable and due to the fact that the types of goods that firms and households demand changes over time. When demand for goods shifts and changes, so does the demand for labor of different skills. For example, the invention of computers decreased the demand for typewriters and the demand for labor in the manufacturing of typewriters. Economists call a change in demand among industries a sectoral shift. Sectoral shifts invariably increase frictional unemployment because it takes time for workers to change sectors and acquire the skills in demand. Therefore, as long as demand and supply among firms for labor are changing, frictional unemployment is inescapable.

The other category of unemployment is structural unemployment. In this case workers are unemployed not because they cannot find suitable jobs for their skills but because there is a mismatch between the number of people who want to work and the number of jobs that are available. A major cause of structural unemployment is wage rigidity, which refers to the failure of wages to balance the supply and demand for labor so that there is no structural unemployment. This occurs when at the going wage rate the quantity of labor supplied exceeds the quantity of labor demanded. There are three common explanations for causes of wage rigidity:

1. Minimum wage legislation is one cause of wage rigidity.
2. Unions can push firms to raise wages and create wage rigidity.
3. Efficiency-wage theories suggest that firms may find it profitable to keep wages high for various reasons, such as enhancing worker morale and productivity.

In Islam, it is our view that employers must pay a wage that at least supports a minimum lifestyle. But beyond this minimum, individuals, through mandated Islamic payments (IP), and the government, through social programs, must elevate the economic well-being of the less fortunate. Moreover, given Islamic teachings in support of hard work and available jobs for all those who can work, it is incumbent on the state to afford employment a high priority in its economic policy objectives. Thus full employment and a wage that affords a minimum living standard to humans to develop and contribute to society should be fixtures of a well-functioning Muslim society. Reducing the unemployment rate may not be easily achieved for either frictional unemployment or structural unemployment. Unemployment is in the end a wasting of resources because those people who cannot find jobs cannot contribute to raise national output despite having the potential to do so. Economists and policy makers monitor the unemployment rate because fluctuations in employment are closely related to fluctuations in aggregate output and human welfare.

The economy is said to be in recession when it experiences a period of falling output (for at least two consecutive quarters) and rising unemployment. Economists call short-run fluctuations in output and employment the business cycle. Fluctuations in GDP and in the unemployment rate are the result of business cycles. Fluctuations in the economy come from changes in aggregate demand and aggregate supply. Aggregate demand determines the quantity of goods and services that people want to buy at any given level of price. Aggregate supply shows the relation between the quantity of goods and services that are supplied and the given price level. Economists call shifts in aggregate supply and demand shocks. A shock that changes aggregate demand is called a demand shock; a shock that changes aggregate supply is called a supply shock. Most economies have what are called automatic stabilizers—income transfers and programs that automatically kick in to increase demand when demand is insufficient (such as unemployment benefits and social programs) and vice versa. Automatic stabilizers should be most significant in the Islamic system as Islam places significant importance on individual, societal, and state support of those with insufficient income (unemployed, disabled, etc.), as discussed in Chapter 8. Policy makers attempt to develop policies that reduce the severity of shocks and economic fluctuations, called stabilization policies. In other words, policy makers try to maintain output and employment close to their natural levels in the long term. To this end, policy makers use appropriate monetary and fiscal policies as an important component of stabilization policy.

Open Economy: Trade in Goods and Services with Other Countries

Up to now, for simplification we have assumed that the economy is a closed economy and does not trade with other countries. In the real world, most countries have open economies. They export and import goods and services from abroad. Also, in an open economy, countries borrow and lend in financial markets. Recall the equation for output in the society:

(6.29)

I can be split into domestic and foreign components—I_d and I_f. The rearranged equation is

(6.30)

I_f is foreign investment, is referred to as the current account, and is equivalent to exports minus imports of goods and services plus net transfer payments (workers' remittances and foreign aid). The current account is the most comprehensive measure of a country's transactions with the rest of the world. A positive current account signifies that a country was a net creditor (investor abroad) to the world in that period of time. In an open economy, financial markets and the goods and services markets are thus closely related. The key difference between an open and a closed economy is that, in an open economy, a country can spend more than it produces by borrowing (foreigners lending or investing) from abroad, or consume less than it produces and lends (or invests) to foreigners. Therefore, contrary to a closed economy, in an open economy, a country's consumption is not necessarily equal to its total output—it can lend (invest) or borrow from the rest of the world. Thus global economic activity becomes an important determinant of local economic activity because it adds to demand and supply.

Islam clearly endorses free trade as it prohibits interferences that inhibit commerce. But an important question that must be addressed is how much sharing is mandated across national borders, especially when it comes to depletable natural resources. Namely, what God has given humans is for all humans of all generations. Thus, do countries need to share only domestically (equal access to all), or with Muslim countries or with all countries regardless of their religion and whether they in turn share their natural resources?

Now we will consider the prices that apply to transactions between international flows of capital and international flows of goods and services. Prices that residents of countries pay to trade with one another are determined by domestic prices and the exchange rate between the currencies of countries. Exchange rate is the price of one currency relative to another. Economists define a number of exchange rates, including the nominal exchange rate and the real exchange rate. The nominal exchange rate is the relative price of the currencies of two countries. For example, we can buy 55 Indian rupees to 1 U.S. dollar. A rise in exchange is called an appreciation or a strengthening of the currency, and a fall in the exchange rate is called depreciation or a weakening of the currency. For example, if the number of Indian rupees needed to buy a dollar rises from 55 to 60, an American can buy more rupees with a dollar and an Indian can buy fewer dollars with a rupee. It is an appreciation of the dollar and a depreciation of the Indian rupee.

The real exchange rate is the nominal exchange rate adjusted for the relative prices of goods. The relationship between the nominal and the real exchange rates is:

If we denote e as a nominal exchange rate (the number of Indian rupees per dollar), P the price level in the domestic country (e.g., in United States), P^* the price level in the foreign country (e.g., India), and the real exchange rate, then the equation can be written as:

(6.31)

The higher real exchange rate signals that foreign goods are relatively cheap and domestic goods are relatively expensive. Clearly the real exchange rate, as opposed to the nominal rate, is the important determinant of trade.

In sum, the real exchange rate is an important determinant of net exports. When the real exchange rate is low, domestic goods are cheaper relative to foreign goods, and net exports will be high ceteris paribus. The current account is the indicator of a country's global savings position; it is positive if the country is a net lender to the rest of the world and negative (a current account deficit) if the country is a borrower—in other words, a country with a current account surplus in a given year is a lender to the rest of the world and one with a deficit is a net borrower.

Why International Trade is so Central to Islam

The conventional theory of international trade is built on the theory of comparative advantage. The message of comparative advantage is profound and is not intuitively obvious. Namely, even if a country has an absolute advantage in the production of every good, it can benefit by specializing in production and engaging in trade. Trade affords a country the opportunity to exchange goods at a different price ratio than that available in the closed home market (increasing the consumption possibility frontier for the country, sometimes referred to as the static gains from trade), and specialization will over time increase productivity growth and output (expanding the production possibility frontier, sometimes referred to as the dynamic gains from trade).

Empirically, while gains from trade are important in economic growth, the dynamic gains are the more significant benefit. Economists, recognizing the gains from trade, almost universally recommend free trade. In addition to the direct economic gains, international affairs specialists focus on the importance of international trade and economic integration (such as common markets and customs unions, the free flow of labor and capital across national borders) for reducing conflicts and wars between countries; two countries that trade extensively and/or are members of a common market recognize that conflict will invariably reduce trade and take a bigger economic toll than for countries that do not trade with each other. In other words, trade and economic integration (free flow of labor, capital, and technology) promote political and social cooperation. It is a unifying factor in human relations, an important goal for any society that professes Islam.

Summary

The most commonly used measure of national economic output is the GDP. There is, however, increasing evidence that GDP does not closely track the level of human and social welfare. In Islam, attaining the highest level of conventional GDP cannot be society's economic goal. Human well-being and social justice are of paramount importance. Thus adjustments must be made to conventional GDP to account for negative externalities (such as environmental degradation), the depletion of nonrenewable resources as well as the output of prohibited goods to derive the Islamic GDP. But even the adjustments that could be made (requiring some new data collection) are insufficient because economic justice is of paramount importance. However, the creation of a level playing field, prevention of large income and wealth disparities, provision of essential social programs, and poverty eradication cannot be integrated into the GDP index of output to arrive at a broad measure of social economic output and social economic performance. Thus the measure of Islamic GDP must be accompanied by strict constraints that any level of output must also provide for these other social and societal objectives.

In the Islamic economic system, the aggregate demand function (consumption, investment, and government expenditures) has a number of differences from that in the conventional economic system. In the case of consumption, Muslims must limit their personal wants, incorporate the needs of others and those of society in their consumption-saving decision, and smooth out their consumption pattern through risk-sharing investments; businesses must incorporate social needs, the negative externalities of their business and investment activities, be motivated by the real rate of return, and raise capital through risk-sharing capital contributions; and government expenditures must provide for the social and infrastructure needs of society, create an economic environment where humans flourish, and manage an economy (through macroeconomic policies) that supports sufficient job creation for all those that can work. It would, however, appear that consumers in Muslim countries do not behave in such a way as to support these expectations, because income and wealth disparities are large, poverty is significant in a number of countries, and opportunities to develop and succeed are highly unequal.

Aggregate demand and aggregate supply interact to determine national economic output. On one hand, classical economics postulates that national economic output cannot be affected by government stabilization policies and is determined by potential output or the economy's capacity to produce (labor, human capital, capital, technology, etc.) as wages and prices are flexible and equate aggregate supply and demand. On the other hand, the Keynesian school argues that in the short run, wages and prices are inflexible and thus aggregate demand may be below or above aggregate supply, resulting in unemployment or in inflation. Thus the Keynesian school recommends stabilization policies (monetary and fiscal) to correct the short-run imbalance, whereas others argue against fiscal policies to adjust economic output and employment and recommend abandoning discretionary monetary policy for a simple monetary rule.

In a truly Islamic system, as long as the state provides efficient institutions, supervision, and rule enforcement, individual Muslims and businesses in caring for the welfare of others in society should provide a number of effective stabilizers that should limit economic fluctuations and large swings in employment and income. Moreover, the fact that real rates of return, instead of highly volatile interest rates, would motivate investment should afford further stability in the Islamic system. Still, in both the conventional economic system and the Islamic system, automatic stabilizers at times will be insufficient to restore economic balance. Thus the state should step in on both the supply side and the demand side through fiscal and monetary policy (see Chapters 12 and 13) to restore balance.

Key Terms

1. National income
2. Gross national product
3. Net national product
4. Consumption
5. Savings
6. Investment
7. Marginal product
8. Wage rate
9. Profit
10. Income determination
11. International trade
12. Exports
13. Imports
14. Exchange rate
15. Government expenditures
16. Taxes
17. Marginal and average propensity to consume
18. Keynesian economics
19. Ricardo's Theory of Comparative Advantage
20. Inflation
21. Velocity of money
22. NAIRU
23. Unemployment
24. Structural and frictional unemployment

Questions

1. Is GDP a good measure of a country's economic output and social welfare? How do you account for economic output from a depletion of a resource (oil) as compared to output from a sustainable base (agriculture)?
2. How would you modify GDP to measure output in the Islamic system?
3. Is GDP per capita a good measure of individual welfare?
4. List some of the reasons people save in Western capitalist economies. Would this list be different for the ideal Islamic economic system?
5. How and why are individual consumption decisions different in the Islamic system from in Western capitalist economies?
6. What is the multiplier? What is its relevance for government economic policy?
7. Why is an economy not always at full employment with stable prices?
8. Do Keynesian economic policies lead to full employment and stable prices?
9. Is a change in taxation and/or government expenditures always helpful in restoring employment and restoring price stability?
10. Why do countries benefit from international trade?
11. Why is the exchange rate an important factor in determining exports and imports? What other variables affect trade?