MBF707: Monetary and Fiscal
Framework in Islamic Finance
COMSATS Institute of Information
Technology (Virtual Campus)
Lecture 29
The Financial System and
Monetary Policy in an
Islamic Economy
(Theoretical Model)
2
Topics Covered
Modes of Financing
Role of Central Banking
3
Topics to Cover
Theoretical Model
Conventional Structure of MP
Structure of the model
a. Banking sector
b. Central bank
c. Public sector
Behavioral Relationships
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The IS curve
def: a graph of all combinations of r and Y that result in
goods market equilibrium,
i.e. actual expenditure (output)
= planned expenditure
The equation for the IS curve is:
Y  C (Y  T )  I (r )  G
Deriving the IS curve
E =Y E =C +I (r )+G
2
E
r
E =C +I (r1 )+G
 I
 E
 Y
I
r
Y1
Y
Y2
r1
r2
IS
Y1
Y2
Y
Why the IS curve is negatively sloped
• A fall in the interest rate motivates firms to
increase investment spending, which drives up
total planned spending (E).
• To restore equilibrium in the goods market,
output (a.k.a. actual expenditure, Y)
must increase.
The IS curve and the Loanable Funds model
(b) The IS curve
(a) The L.F. model
r
S2
r
S1
r2
r2
r1
r1
I (r )
S, I
IS
Y2
Y1
Y
Fiscal Policy and the IS curve
• We can use the IS-LM model to see
how fiscal policy (G and T) affects
aggregate demand and output.
• Let’s start by using the Keynesian Cross
to see how fiscal policy shifts the IS curve…
Shifting the IS curve: G
At any value of r, G
 E  Y
E =Y E =C +I (r )+G
1
2
E
E =C +I (r1 )+G1
…so the IS curve
shifts to the right.
The horizontal
distance of the
IS shift equals
r
Y1
Y
Y2
r1
Y
1
Y 
G
1 MPC
Y1
IS1
Y2
IS2
Y
Exercise: Shifting the IS curve
• Use the diagram of the Keynesian Cross or
Loanable Funds model to show how an
increase in taxes shifts the IS curve.
The Theory of Liquidity Preference
• due to John Maynard Keynes.
• A simple theory in which the interest rate
is determined by money supply and
money demand.
Money Supply
r
The supply of
real money
balances
is fixed:
M
interest
rate
M
P
s
P M P
s
M P
M/P
real money
balances
Money Demand
r
Demand for
real money
balances:
M
P
d
interest
rate
M
P
s
 L (r )
L (r )
M P
M/P
real money
balances
Equilibrium
The interest
rate adjusts
to equate the
supply and
demand for
money:
r
interest
rate
M
P
s
r1
L (r )
M P  L (r )
M P
M/P
real money
balances
How the Fed raises the interest rate
r
To increase r, Fed
reduces M
interest
rate
r2
r1
L (r )
M2
P
M1
P
M/P
real money
balances
Theoretical Model of the Islamic Financial
System
 The model incorporates the principal characteristics
of Islamic banking outlined earlier in our discussion.
This model is modified version of financial models of
Brainard (1967), Tobin (1969), and Modigliani and
Papademos (1980) which are the standard in
monetary theory.
 This model discusses the basic accounting structure
of the model, the underlying behavioral relationships,
and finally, the effects of monetary policy.
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Theoretical Model
1.
Structure of the model
a. Banking sector
b. Central bank
c. Public sector
2. Behavioral relationships
3. Solution of the model
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A Theoretical Model: Structure of the model
The financial side of the economy is composed
of commercial banks, central bank, and the
non-bank public.
Additionally, the model contains a single
commodity that is both produced and
consumed domestically.
For simplicity, the economy is assumed to be
closed so that there is no trade or capital
movements.
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Theoretical Model: Banking Sector
 Commercial banks will offer only investment
deposits to the public which are not guaranteed by the
banks and do not yield a predetermined rate of return.
 The banks are assumed to pay depositors a rate of
return that is based on profits from their operations.
 These profits are shared between the depositor and
the bank in some mutually-agreed proportion
determined prior to the transaction, so that return is
the depositor's share of the bank profits as a
proportion of his deposit.
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Theoretical Model: Banking Sector
 The rate of return received by deposits will thus
fluctuate according to variations in bank profits
and/or the stock of deposits. The profit-sharing ratio
is assumed to remain fixed for the duration of the
contract.
 Commercial banks in the Islamic system cannot
borrow from the central bank through the mechanism
of rediscounting at a given official discount rate.
 Banks can borrow from the central bank only on an
equity-participation basis.
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Theoretical Model: Banking Sector
 That is, the central bank purchases equity in the bank
when it wishes to expand reserves in the system, and
vice versa.
 Therefore, an additional source of funds for
commercial banks becomes the sale of equity shares
to the central bank.
 The rate of return on equity shares would depend on
the overall profit position of banks, so that in contrast
to an official discount rate, it would not be
determined directly by the central bank.
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Theoretical Model: Banking Sector
 On the lending side banks engage in only risk-return
sharing Mudarabah arrangements with the public.
 Mudarabah financing in this case is assumed to
subsume all other types of similar arrangements, such
as Musharaka financing.
 As in the case of investment deposits, the profits
earned from the projects financed by the bank are
shared between the bank and the entrepreneur on a
prearranged basis specified in the contract between
the two before the financing is provided.
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Theoretical Model: Banking Sector
 The rate of return the banks receive will be related to
the rate they pay on their liabilities, with the spread
essentially covering operating and other costs.
 If such costs are assumed to be zero, the rate of return
on loans will be equal to rate of return on deposits.
 The banks would thus be receiving profit-sharing
ratio in favor of the bank.
 Higher share of return to the bank would reduce the
demand for loans.
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Theoretical Model: Banking Sector
 Banks are also required to hold a certain proportion
of their liabilities to the public in the form of reserves
with the central bank.
 Whether investment deposits should be subject to
legal reserve requirements or not (Debatable)
 It is assumed so far that banks hold reserves at the
central bank without necessarily implying that such
holdings are mandatory.
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Theoretical Model: Central Bank
 The central bank's liabilities consist of reserves of
commercial banks.
 The high-powered money in the economy is by
definition equal to the stock of bank reserves.
 On the asset side the central bank holds equity shares
of commercial banks, and the rate of return on these
is market determined.
 The supply of reserves is changed by the central bank
through variations in its stock of bank equity shares.
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Theoretical Model: Public Sector
 Since commercial banks are the only financial
intermediaries in the economy, investment deposits in
the banking system represent the financial wealth of the
public.
 Total wealth of the public is equal to financial wealth
and its stock of capital.
 The public has basically two sources of funds: first,
Mudarabah financing, and second, its own savings (S).
 In the absence of a debt market, any desired increase in
assets (financial or total) has to be accommodated
through one of these sources.
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Theoretical Model: Public Sector
 Any model that attempts to explain this type of
economy would have to necessarily ensure
consistency with the flow of funds accounts.
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Theoretical Model:
Behavioral relationships
 The monetary policy in an Islamic economy is a
variant of the standard IS-LM model.
 While relatively simple in structure the model
developed is sufficiently general to incorporate the
balance sheet restrictions.
Three important assumptions:
a) All changes in income will reflect variations in real
output.
b) Expectations of economic agents are fully realized.
c) The real and the financial sector are assumed to be
in continuous equilibrium.
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Theoretical Model:
Behavioral relationships
 IS relationship is derived assuming that investment is
a negative function of the rate of return on
Mudarabah financing, and savings a positive function
of income.
 Net wealth at the beginning of the period is assumed
to affect both investment and savings, with the former
effect dominating.
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Theoretical Model:
Behavioral relationships
There are three financial assets in the LM model:
a) bank loans
b) investment deposits
c) equity shares of commercial banks.
 The public's demand for Mudarabah financing is
specified as a function of the banks' required rate of
return, and net wealth at the beginning of the period.
 The banking sector's supply of Mudarabah financing
can be specified as a positive function of the rate of
return, and a negative function of the cost of
borrowing for banks.
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Theoretical Model:
Behavioral relationships
 This cost will be effectively the rate of return on the
banks equity shares held by the central bank.
 The sale and repurchase of its equity is the only way a
bank is assumed to be able to augment or reduce its
resources.
 This operation is equivalent to the use of a
rediscounting mechanism, or quasi discount rate.
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Thank You
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