iii

THE REPUBLIC OF TURKEY

ERCİYES UNIVERSITY
INSTITUTE OF SOCIAL SCIENCES
DEPARTMENT OF ECONOMICS

CENTRAL BANKING AND THE MONETARY POLICY:

EXAMINING THE SUPERIORITY OF THE ISLAMIC
MONETARY SYSTEM ON THE BASIS OF STABILITY IN THE
MONEY DEMAND FUNCTION UNDER A DUAL BANKING
SYSTEM
(PhD Thesis)

By
Abubakar BYANGO

Supervisor
Prof. Dr. Ekrem ERDEM

December 2020
KAYSERİ
 i

COMPLIANCE WITH SCIENTIFIC ETHICS

I hereby declare that all information in this document has been obtained and presented in
accordance with the academic rules and ethical conduct. I also declare that, as required
by these rules and conduct, I have fully cited and referenced all material and results that
are not original to this work.

Name and Surname: Abubakar BYANGO

Signature:
 ii

THESIS PLAGIARISM SUBMISION FORM

THE REPUBLIC OF TURKEY

ERCİYES UNIVERSITY
Directorate of the Institute of Social Sciences

Thesis Title: Central Banking and the Monetary Policy: Examining the Superiority of the
Islamic Monetary System on the basis of Stability in the Money Demand Function under
a Dual Banking System. The similarity rate of my thesis according to the originality
report obtained from Turnitin plagiarism program on 28/12/2020 by applying the filtering
stated below is 20%.

Filters applied:
1- Introduction included
2- Main Chapters included
3- Results included
4- Citations included / excluded
5- Cover excluded
6- Preface and Acknowledgment excluded
7- Table of contents excluded
8- References excluded
9- Abstract excluded
10- Parts of the text containing less than seven (7) overlapping words excluded

I have reviewed the applied regulations of Erciyes University Institute of Social Sciences.
Thesis Plagiarism Report and I declare that my thesis study does not contain any
plagiarism according to the maximum similarity rates specified in these applied
Principles, I accept all kinds of legal liability that may arise in possible situations where
the opposite will be determined and the information I have given above is correct.

I hereby submit my information ……/……./…….

Name Surname: Abubakar BYANGO

Student No: 4030341510

Main Department: Economics

Department: Economics

Program Name: Ph.D. Economics program

Supervisor: Prof. Dr. Ekrem ERDEM Student: Abubakar BYANGO

 iii

APPROVAL OF COMPLIANCE WITH THE DIRECTIVES

‘‘Central Banking and the Monetary Policy: Examining the Superiority of the
Islamic Monetary System on the basis of Stability in the Money Demand Function
under a Dual Banking System.’’ The Doctorate thesis named above, has been prepared
in accordance with Erciyes University Graduate Thesis Proposal and Thesis Writing
Directives.

Thesis Prepared by Supervisor

Abubakar BYANGO Prof. Dr. Ekrem ERDEM

Signature: Signature:

Head of The Department of Economics

Prof. Dr. Ferit KULA

Signature:
 iv

ACCEPTANCE AND APPROVAL

In accordance with the decision of the Council of Higher Education dated 03/06/2020 and
numbered 32794, "Thesis Approval Page" is not included.
 v

ACKNOWLEDGEMENT

In the name of Allah, the Most Gracious, the Most Merciful. All Praise be to Him,
The Cherisher and Sustainer of the Worlds. May His peace and blessings be bestowed
upon His last Messenger Muhammad (PBH) and his impeccable family.

I would like to begin by expressing my deepest heartfelt indebtedness to Prof. Dr. Ekrem
Erdem, my supervisor for the great role he has played during my academic cycle at this
university. His untiring supervision, guidance, mentorship, and moral support among
other virtues have been the pillars to my course success thus far. Most importantly,
without his fundamental advice, suggestions and keen eye that yielded all the positive
criticisms, this thesis would never have achieved the level of precision and intensity it
now possesses. Similarly, I wish to extend my gratitude to my other two supervisors: Prof.
Dr. Hatice Erkekoğlu and Ass. Prof. Dr. Cüneyt Dumrul, for their continuous guidance
and encouragement of me throughout my research period. I wish to also acknowledge
Prof. Dr. Hayriye Atik and Prof. Dr. Can Tansel Tuğcu for their tremendous scrutny of
my thesis before my viva voce. I am sincerely grateful to all of you for your great work.
I also thank all the teaching and non-teaching staff members at the economics department,
who in one way or another helped or supported me to push forward until this milestone
was reached. I specifically would lıke to thank Mr. Savaş Savaş for his untirıng help to
us throughout our study period. Thank so much.

In a special way, I am highly indebted and owe a great appreciation to my dear wife Mrs.
Aisha Nalusaji whose goals have in many cases been rendered second for me to succeed
academically. I honestly cannot thank you enough but please know that you are indeed a
treasure in my life. To my children, Husnah Nabuhilarah, Abubakar Kudi, Abdulhafiz
Byango, and Hannah Nankwanga, you are the real reason that keeps me smiling and
aiming higher. My brothers and sisters thank you for being there for me. I also wish to
thank all my colleagues at the faculty of economics and administrative sciences and
indeed everyone who has been there for me in one way or another. Thank you so much
all for your profound support.

Lastly, this study has been pursued as a partial fulfilment for the award of a PhD in
economics. So, as a scholarship student, I would like to express my utmost gratitude and
appreciation to the government of the Republic of Turkey that has funded my study
through YTB.
 vi

CENTRAL BANKING AND THE MONETARY POLICY: EXAMINING THE

SUPERIORITY OF THE ISLAMIC MONETARY SYSTEM ON THE BASIS OF
STABILITY IN THE MONEY DEMAND FUNCTION UNDER A DUAL
BANKING SYSTEM

Abubakar BYANGO

Erciyes University, Institute of Social Sciences

Ph.D. Thesis, December 2020
Supervisor: Prof. Dr. Ekrem ERDEM

ABSTRACT

Central banking operations in managing monetary policy is the main and most important
segment of any economy, Islamic or otherwise. As the level of Islamic banking and
financial practices increase, the hypothesis that the Islamic monetary system is more
efficient and effective compared to its conventional counterpart galvanizes more
momentum. However, no single country with dual banking and financial systems has
implemented monetary policy from the Islamic framework. The motivation for
undertaking this research, therefore, was prompted by the realisation from the literature
that despite the enormous efforts by various Muslim countries to re-align the banking and
finance sectors towards the Islamic principles, central banking and monetary policy
operations have largely continued in the conventional framework. So, ceteris paribus, the
continued insistency by Muslim countries on interest-based monetary practices, whose
collateral economic and financial failures have been well documented raises doubt about
the superiority of the Islamic monetary policy alternatives. The purpose of this study,
therefore, is to examine this superiority both theoretically and empirically under dual
monetary and financial systems.
Our empirical part employed annual data, secondary in nature, collected from the
International Monetary Fund (IMF), International Financial Statistics (IFS), and the
World Bank. It spans from 1991-2016 inclusive, making a total of 26 observations for
eight cross-sections. Empirically, the study extended the literature by way of comparing
two monetary systems based on the relative stability of the money demand function, the
relative stability of the velocity of money and the correlation between the monetary
aggregates and the monetary base as well as the monetary policy goal and the monetary
aggregate of the Islamic monetary system over the conventional one. The study employs
 vii

the panel DOLS and FMOLS cointegration techniques for the estimations of the long-run
demand for money. For the short-run regression tests, the study employed the bounds
ARDL model and thereafter examined the stability of the money demand functions under
the two systems using plots of CUSUM and CUSUM SQ for each cross-section.
The findings of the study are categorized into two; theoretical and empirical. Under the
theoretical analysis, the epistemological foundations showing the relative superiority,
effectiveness, and efficiency of an interest-free financial and monetary system in
facilitating the achievement of macroeconomic goals especially sustainable price and
financial stability was examined. We cited several divine guidance as the basis and
foundation for a proper economic order which has guided mankind throughout all passed
generations as mentioned in the major divine scriptures including the Holy Quran, the
Bible, the Torah, and the words, behaviours, and actions of Prophet Muhammad (PBH).
The study demonstrated how the Islamic monetary system facilitates the achievement of
macroeconomic goals in a more efficient and effective manner as compared to its
conventional counterpart. Lastly, the theoretical part concluded that when fully
operationalized, an Islamic monetary and financial system operates at its optimal level.
At this level, not only are the goals of monetary policy; price and financial stability at
high output level achieved but also the unemployment is solved.
From the empirical results, the study found expected inflation rate as a perfect
replacement for the prohibited interest rate as the both long-run cointegration and the
short-result regression results conformed to the behavioural economic theory. The
CUSUM and CUSUMSQ plots showed that both models are relatively stable since they
lie within the 5% critical region. This could be attributed to the replacement of interest
rate with expected inflation rate as the opportunity cost variable. Our justification for
dropping the interest rate variable was not only based on the fact that interest rates have
no room for an Islamic economic order but also, increasingly, the expected inflation, not
interest rate is gaining general acceptability as the most appropriate measure for the
opportunity cost of holding money especially in developing countries (Bahmani, Oskooee
and Tanku, 2006; Budina et al., 2006). Findings prove that variance of velocity of interest-
free money is much lower than that of the interest-based, consisting with the earlier
studies on the subject matter that stressed that interest-free monetary aggregate is less
volatile as compared to its interest-based counterpart. Moreover, the correlation between
the monetary base and the monetary aggregate as well the link between the ultimate
 viii

monetary policy goal (sustainable price stability) and the monetary aggregate was found
to be relatively stronger under the Islamic monetary system compared to the ones under
the conventional system.
The findings of this study have important policy-making implications to a wide spectrum
of stakeholders including academia, policymakers, regulators, and practitioners. Lastly,
this study has tried to fill the gap in the literature, on the general lack of empirical support
as regards the stability of the money demand function as a pre-requisite for the successful
implementation and achievement of any monetary policy goal in an effective and efficient
way.
Key words: Islamic monetary policy, Islamic central banking, Islamic financial system,
estimation of the money demand function, conventional monetary system, Cointegration,
Interest-free monetary aggregate and interest based monetary aggregate (money supply).
 ix

MERKEZ BANKACILIĞI VE PARA POLİTİKASI: İKİLİ

BANKACILIKSİSTEMİ ALTINDA PARA TALEBİ FONKSİYONUNUN
İSTİKRARINDAN HAREKETLE İSLAMİ PARA SİSTEMİNİN
ÜSTÜNLÜĞÜNÜN İNCELENMESI

Abubakar BYANGO

Erciyes Üniversitesi, Sosyal Bilimler Enstitüsü

Doktora Tezi, Aralık 2020
Danışman: Prof. Dr. Ekrem ERDEM

ÖZET

Para politikasını yönetmede merkez bankacılığı işlemler, İslami olsun ya da olmasın her
ekonominin ana ve en önemli unsurudur. İslami bankacılık ve finans uygulamaların
seviyesi yükseldikçe, İslami para sisteminin geleneksel muadiline göre daha verimli ve
etkili olduğu hipotezi gün geçtikçe daha fazla geçerlilik kazanmaktadır. Bununla birlikte,
ikili bankacılık ve finansal sistemlere sahip hiçbir ülke İslami çerçevede para politikası
uygulamamaktadır. Bu araştırmanın temel motivasyonu, muhtelif Müslüman ülkelerin
bankacılık ve finans sektörlerini İslami ilkelere göre yeniden düzenlemeye yönelik büyük
gayretlerine rağmen, merkez bankacılığı ve para politikası operasyonlarının halen büyük
ölçüde geleneksel şekilde devam etmesidir. Müslüman ülkelerin faize dayanan para
politikası uygulamalarının ekonomik ve finansal olarak başarısız olduğu açıkça ortaya
konulmuş olmasına rağmen, faize dayalı para politikasi uygulamalarına devam eden
ısrarları, İslami para politikası alternatifinin üstünlüğü hakkında şüphe uyandırmaktadır.
Dolayısıyla, bu çalışmanın amacı, bu üstünlüğü hem teorik hem de ampirik olarak ikili
parasal ve finansal sistemler altında incelemektir.
Çalışmanın uygulama kısmında Uluslararası Para Fonu (IMF), Uluslararası Finansal
İstatistikler (IFS) ve Dünya Bankası’ndan elde edilen ikincil yıllık veriler kullanılmıştır.
8 yatay kesitten elde edilen 26 gözlem 1991-2016 yıllarını kapsayacak şekilde analize
dahil edilmiştir. Uygulama kısmı her iki parasal sistemi para talebi fonksiyonunun
göreceli istikrarına, paranın dolaşım hızının göreceli istikrarına, parasal toplamlar ile
parasal taban arasındaki korelasyona ve aynı zamanda para politikası hedefi ve geleneksel
olana göre İslami para sisteminin parasal toplamını dikkate alarak mevcut literatürü
genişletmektedir. Çalışmada, uzun vadeli para talebinin tahminleri için panel DOLS ve
 x

FMOLS eşbütünleşme teknikleri kullanılmıştır. Kısa dönemli regresyon testleri için,

ARDL sınır testi kullanılmış ve her iki sistemde para talebi fonksiyonunun istikrarlılığı
her bir kesit için CUSUM ve CUSUMSQ grafikleri kullanılarak incelenmiştir.
Çalışmanın bulguları teorik ve ampirik olmak üzere iki kategoride ele alınabilir. Teorik
analiz kapsamında, özellikle sürdürülebilir fiyat ve finansal istikrar başta olmak üzere,
makro-ekonomik hedeflere ulaşılmasını kolaylaştırmada faizsiz bir finansal ve parasal
sistemin göreceli üstünlüğünü ve etkinliğini gösteren epistemolojik temeller
incelenmiştir. Kuran-ı Kerim, İncil, Tevrat ve Hz. Muhammed’in (PBH) sözleri,
davranışları ve eylemleri de dahil olmak üzere, başlıca kutsal kitaplarda bahsedildiği gibi,
insanlığa geçen nesiller boyunca rehberlik eden bir ekonomik düzenin temeli
incelenmiştir. Çalışma, İslami para sisteminin geleneksel muadiline kıyasla makro-
ekonomik hedeflere daha verimli ve etkili bir şekilde ulaşılmasını nasıl kolaylaştırdığını
görtermektedir. Son olarak, teorik kısımda, İslami bir para ve finans sisteminin tam
anlamıyla faaliyete geçtiğinde optimal düzeyde çalışacağı sonucuna varılmıştır.. Bu
seviyede, sadece para politikasının yüksek hasıla düzeyinde fiyat ve finansal istikrar
hedeflerine ulaşılmış olmayacak, aynı zamanda işsizlik sorunu da çözülmüş olacaktır.
Ampirik sonuçlar beklenen enflasyon oranının hem uzun vadeli eşbütünleşme hem de
kısa sonuçlu regresyon, sonuçlarının davranışsal iktisat teorisine uygun olması nedeniyle
yasaklanmış enflasyon oranının mükemmel bir ikamesi olduğunu ortaya koymaktadır.
CUSUM ve CUSUMSQ grafikleri her iki modelin de %5’lik anlam seviyesinde nispeten
istikrarlı olduğunu göstermektedir. Bu, faiz oranının fırsat maliyet değişkeni olarak
beklenen enflasyon oranıyla değiştirilmesi ile açıklanabilir. Faiz oranı değişkenini
kullanmama gerekçemiz sadece faiz oranlarının İslami bir ekonomik düzende yer
almaması gerçeğine değil, aynı zamanda faiz oranının aksine beklenen enflasyonun
özellikle gelişmekte olan ülkelerde para tutmanın fırsat maliyetini, daha iyi yansıtan bir
araç olduğu konusundaki genel kabuldür (Bahmani, Oskooee ve Tanku, 2006; Budina
vd., 2006Bulgular bize faizsiz paranın dolaşım hızının varyansının faize dayalı olana göre
çok daha düşük olduğunu gösteriyor. Bu sonuç, faizsiz parasal toplamların faize dayalı
olanlara göre daha az oynaklık gösterdiği yönünde daha önceki bulgularla örtüşmektedir.
Ayrıca, para tabanı ile parasal toplam arasındaki korelasyon ve nihai para politikası hedefi
(sürdürülebilir fiyat istikrarı) ile parasal toplamlar arasındaki bağlantı, İslami para
sisteminde geleneksel sistemdekilere göre görece daha güçlü bulunmuştur.
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Bu çalışmanın bulguları akademi, politika yapıcılar, düzenleyiciler ve uygulayıcılar başta

olmak üzere, geniş bir paydaş yelpazesi için önemli politika çıkarımlarına sahiptir. Son
olarak, bu çalışma, herhangi bir para politikası hedefinin etkin ve verimli bir şekilde
uygulanması ve gerçekleştirilmesi için bir ön koşul olarak para talebi fonksiyonunun
istikrarına ilişkin genel ampirik destek eksikliği üzerine literatürdeki boşluğu doldurmaya
çalışmıştır.
Anahtar Kelimeler: İslami para politikası, İslami merkez bankacılığı, İslami finans
sistemi, para talebi fonksiyonunun tahmini, geleneksel para sistemi, eşbütünleşme, faizsiz
ve faize dayalı para arzı (parasal toplamlar).
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TABLE OF CONTENTS

CENTRAL BANKING AND THE MONETARY POLICY: EXAMINING THE

SUPERIORITY OF THE ISLAMIC MONETARY SYSTEM ON THE BASIS OF
STABILITY IN THE MONEY DEMAND FUNCTION UNDER A DUAL
BANKING SYSTEM.

COMPLIANCE WITH SCIENTIFIC ETHICS ................................................................ i

THESIS PLAGIARISM SUBMISION FORM ................................................................ ii

APPROVAL OF COMPLIANCE WITH THE DIRECTIVES ...................................... iii

ACCEPTANCE AND APPROVAL ............................................................................... iv

ACKNOWLEDGEMENT .................................................................................................v

ABSTRACT .................................................................................................................... vi

ÖZET ............................................................................................................................... ix

TABLE OF CONTENTS ............................................................................................... xii

TABLES ........................................................................................................................ xix

FIGURES ...................................................................................................................... xxi

LIST OF ABBREVIATIONS ..................................................................................... xxiv

INTRODUCTION ...........................................................................................................1

CHAPTER ONE

1.1. Introduction ............................................................................................................ 8

1.2. Background of the study ........................................................................................ 8

1.3. Problem Statement ............................................................................................... 11

1.4. Aims and objectives of the study ......................................................................... 14

1.5. Research questions of the study ........................................................................... 18

1.6. Significance of the study...................................................................................... 19

1.7. Contributions of the study.................................................................................... 19

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1.8. Scope and limitations of the study ....................................................................... 21

1.9. Organization of the study ..................................................................................... 22

1.9.1. Chapter One: Introduction............................................................................. 22

1.9.2. Chapter Two: An overview of the conventional financial and monetary system 22

1.9.3. Chapter Three: An overview of the Islamic financial and monetary system 23

1.9.4. Chapter Four: A review of the related literature ........................................... 23

1.9.5. Chapter Five: Theoretical foundations on the superiority of the Islamic ...... 23

1.9.6. Chapter Six: Methodology and empirical estimations of the study .............. 23

CHAPTER TWO

AN OVERVIEW OF THE CONVENTIONAL MONETARY POLICY

FRAMEWORKS AND CENTRAL BANKING

2.1. Introduction .......................................................................................................... 24

2.2. The Conventional Central Banking and the Financial system ............................. 24

2.3. History and evolution of the conventional central banking and the monetary system
.................................................................................................................................... 26

2.4. The origin of money............................................................................................. 29

2.5. Roles and functions of the Conventional Central Banks ..................................... 30

2.6. Tools of central banking and monetary policy .................................................... 37

2.6.1. Open market operations (OMO) ................................................................... 37

2.6.1.1. Outright open market operations (Repos) .............................................. 38

2.6.1.2. Temporary open market operations (Repos and Reverse Repos)........... 38

2.6.2. Discount window lending (DR) .................................................................... 38

2.6.3. Legal reserve requirement (LRR) ................................................................. 39

2.6.4. Moral suasion ................................................................................................ 40

2.6.5. Selective credit controls ................................................................................ 40

2.7. Objectives, Targets, Goals and Priorities of Conventional Central Banking and
Monetary Policy .......................................................................................................... 41
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2.7.1. Goals ............................................................................................................. 41

2.7.2. Priority........................................................................................................... 42

2.7.3. Monetary policy targets and strategies .......................................................... 43

2.8. The theory of interest rate under the conventional system .................................. 44

2.9. Conventional mechanisms of monetary policy transmission .............................. 50

2.9.1. Direct monetary channel ............................................................................... 50

2.9.2. The credit channel ......................................................................................... 52

2.9.3. The interest rate channel ............................................................................... 53

2.9.4. Asset price channel ....................................................................................... 55

2.9.5. The expectation channel ................................................................................ 57

CHAPTER THREE

AN OVERVIEW OF ISLAMIC CENTRAL BANKING AND MONETARY

POLICY SURVEY

3.1. Introduction .......................................................................................................... 59

3.2. History of the Islamic central banking and the monetary system ........................ 59

3.3. The Islamic concept of money and its role .......................................................... 63

3.4. The functions of Islamic central banking............................................................. 66

3.5. Goals, Objectives, and Targets of the Islamic Central Bank ............................... 67

3.6. Islamic banking, finance, and monetary policy principles .................................. 68

3.6.1. The prohibition of interest (riba /usury) ....................................................... 69

3.6.2. The prohibition of uncertainty and speculative practices (gharar and maysir) ...70

3.6.3. Prohibition of haram (unlawful) earnings..................................................... 71

3.6.4. Prohibition of hoarding of coins ................................................................... 72

3.6.5. Profit-and-Loss Sharing (PLS) obligation .................................................... 72

3.6.6. Asset-backed obligation and principle .......................................................... 73

3.7. The basic Islamic banking and financial tools ..................................................... 73

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3.7.1. Mudarabah (joint venture financing) ............................................................ 75

3.7.2. Musharakah (Joint venture)........................................................................... 76

3.7.3. Murabahah (cost-plus financing) .................................................................. 76

3.7.4. Ijarah (Islamic leasing) .................................................................................. 77

3.7.5. Wakalah (Agency contract)........................................................................... 78

3.7.6. Salaam contract (advance purchase) ............................................................. 79

3.7.7. Istisna’a ......................................................................................................... 80

3.7.8. Sukuk (participation securities)..................................................................... 81

3.8. The contemporary financial and monetary practices of Muslim countries.......... 87

3.8.1. Islamic banking, finance, and monetary policy practices of the selected
countries .................................................................................................................. 87

3.8.2. An illustration of the contemporary Islamic finance system as practiced in 96

3.9. Conclusion ......................................................................................................... 102

CHAPTER FOUR

REVIEW OF THE LITERATURE

4.1. Introduction ........................................................................................................ 103

4.2. Theoretical propositions..................................................................................... 104

4.3. Empirical related literature ................................................................................ 108

4.4. Conclusion ......................................................................................................... 113

CHAPTER FIVE

SUPERIORITY OF THE ISLAMIC MONETARY SYSTEM BASED ON ITS

THEORETICAL AND DIVINE FOUNDATIONS

5.1. Introduction ........................................................................................................ 114

5.2. The theoretical framework on demand for money ............................................. 119

5.2.1. Variables in the demand for money ............................................................ 119

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5.3. Sources of Inflation ............................................................................................ 126

5.3.1. The classical theory ..................................................................................... 127

5.2.2. The Keynesian View ................................................................................... 130

5.3.3. The Monetarist View................................................................................... 131

5.3.4. The New classical view ............................................................................... 132

5.3.5. The New Keynesian view ........................................................................... 133

5.3.6. The Islamic view of inflation ...................................................................... 134

5.4. Conclusion ......................................................................................................... 145

CHAPTER SIX

METHODOLOGY, EMPIRICAL ESTIMATIONS, ANALYSIS, DISCUSSION

AND RECOMMENDATIONS

6.1. Introduction ........................................................................................................ 146

6.2. Data Variables and their sources........................................................................ 146

6.3. The basic money demand function .................................................................... 147

6.4. The demand for money and panel DOLS and FMOLS approaches .................. 148

6.5. The Demand for money and the ARDL approach ............................................. 153

6.6. Variable description ........................................................................................... 155

6.7. Dependent Variables .......................................................................................... 156

6.7.1. M1 (IFMP) .................................................................................................. 156

5.7.2. M2 (IBMP) .................................................................................................. 157

6.8. Independent Variables ....................................................................................... 158

6.8.1. Real gross domestic product (GDP). ........................................................... 158

6.8.2. Expected inflation rate ................................................................................ 158

6.8.3. Real effective exchange rate (REER).......................................................... 160

6.9. Descriptive statistics of the data variables ......................................................... 162

6.10. Panel descriptive statistics of the variables...................................................... 163

 xvii

6.11. The trends of the dependent variables for individual cross sections ............... 166

6.12. Panel Cross-section dependence Tests............................................................. 169

6.13. Panel unit root tests .......................................................................................... 170

6.14. Panel cointegration tests .................................................................................. 177

6.14.1. Pedroni panel cointegration testing ........................................................... 177

6.14.2. Kao panel cointegration test ...................................................................... 178

6.14.3. Johansen/Fisher panel cointegration test ................................................... 179

6.13.4. Durbin-Hausman panel cointegration test ................................................. 180

6.14. Panel causality test using both the pairwise Granger causality and Dumitrescu-
Hurlin panel causality tests ....................................................................................... 184

6.14.1. Pairwise panel Granger-causality test ....................................................... 184

6.14.2. Pairwise Dumitrescu Hurlin panel causality test ...................................... 185

6.15. Empirical Estimations ...................................................................................... 190

6.15.1. Long-run panel estimation ........................................................................ 190

6.15.2. Results for the long-run country specific estimations ............................... 195

6.15.3. Short-run coefficients estimated using ARDL model ............................... 197

6.15.4. Comparison of money demand function stability for the two systems using
plots of cumulative sum of recursive residuals and cumulative sum of squares of
recursive residuals ................................................................................................. 200

6.15.4.1. The plots of cumulative sum of recursive residuals and cumulative sum
of squares of recursive residuals ........................................................................ 201

6.15.4.1.1. Bahrain ......................................................................................... 201

6.15.4.1.2. Malaysia ....................................................................................... 203

6.15.4.1.3. Indonesia ...................................................................................... 204

6.15.4.1.4. Kuwait .......................................................................................... 205

6.15.4.1.5. Qatar............................................................................................. 207

6.15.4.1.6. Saudi Arabia................................................................................. 208

6.15.4.1.7. Pakistan ........................................................................................ 209

6.15.4.1.8. Turkey .......................................................................................... 211

 xviii

6.16. Comparison of the variance of velocity of money under the two monetary systems
.................................................................................................................................. 212

6.17. The correlation between monetary aggregates and the monetary base............ 215

6.18. Study results, monetary policy implications and policy recommendations..... 219

6.19. Summary of findings and recommendations ................................................... 227

REFERENCES ............................................................................................................233
 xix

TABLES

Table 2.1. Operations of the central bank in pursuit of its monetary policy goals .. 44

Table 3.1. Comparison of the Islamic and conventional concept of money ............ 66

Table 3.2. Islamic banking and finance instruments ................................................ 75

Table 3.3. Characteristics of Islamic and the conventional monetary systems........ 93

Table 3.4. Comparison of the characteristics of the Islamic monetary system,

conventional system, and the practices of contemporary Muslim majority
countries .................................................................................................. 95

Table 3.5. Summary of the major differences between convention and the Islamic
monetary systems .................................................................................. 102

Table 6.1. Panel descriptive statistics of the variables ........................................... 163

Table 6.2. Test results of the cross-section dependence tests for the variables ..... 170

Table 6.3. Panel unit root tests using first generation techniques. ......................... 173

Table 6.4. Panel unit root tests using the second-generation technique ................ 175

Table 6.5. Country specific unit roots (Phillips-Perron) ........................................ 176

Table 6.6. Panel cointegration tests results ............................................................ 182

Table 6. 7. Panel cointegration tests results ............................................................ 183

Table 6. 8. Pairwise panel causality tests with M1 (LIFMP) as the dependent variable
............................................................................................................... 186

Table 6.9. Pairwise panel causality tests with M2 / LIBMP as the dependent variable
............................................................................................................... 187

Table 6.10. Results of panel estimation of cointegrating regression under Interest-free

monetary policy (IFMP) ...................................................................... 190

Table 6.11. Results of panel estimation of cointegrating regression coefficients under

interest-based monetary policy (IBMP) ................................................ 192

Table 6.12. Long-run country specific estimation of cointegration regression

coefficients under the interest-free monetary system (IFMP) .............. 195
 xx

Table 6.13. Long-run country specific estimation of co-integration regression

coefficients under the interest-based system (IBMP) ........................... 196

Table 6.14. F-values based on ARDL model ........................................................... 198

Table 6.15. Short-run country specific estimation of cointegration regression

coefficients ............................................................................................ 199

Table 6.16. Lag order selection used Akaike information criterion (AIC) .............. 201

Table 6.17. Lag order selection used Akaike information criterion (AIC) .............. 202

Table 6.18. Lag order selection used; Akaike information criterion (AIC) ............. 203

Table 6.19. Lag order selection used Akaike information criterion (AIC) .............. 203

Table 6.20. Lag order selection used Akaike information criterion (AIC) .............. 204

Table 6.21. Lag order selection used Akaike information criterion (AIC) .............. 205

Table 6.22. Lag order selection used Akaike information criterion (AIC) .............. 205

Table 6.23. Lag order selection used; Akaike information criterion (AIC) ............. 206

Table 6.24. Lag order selection used: Akaike information criterion (AIC) ............. 207

Table 6.25. Lag order selection used: Akaike information criterion (AIC) ............. 207

Table 6.26. Lag order selection used: Akaike information criterion (AIC) ............. 208

Table 6.27. Lag order selection used Akaike information criterion (AIC) .............. 209

Table 6.28. Lag. order selection used Akaike information criterion (AIC) ............. 209

Table 6.29. Lag order selection used Akaike information criterion (AIC) .............. 210

Table 6.30. Lag order selection used Akaike information criterion (AIC) .............. 211

Table 6.31. Summary statistical results of velocity and the variance of velocity of
money under the two monetary systems ............................................... 214

Table 6.32. The correlation between monetary aggregates and monetary base ...... 216

Table 6.33. The correlation between price and monetary aggregate ....................... 218
 xxi

FIGURES

Figure 1.1. Showing Global Share of Islamic Finance Assets .................................. 16

Figure 2.1. The general impact of interested-based monetary policy ....................... 47

Figure 2.2. Credit demand and supply constraints during macroeconomic shocks in
the conventional system .......................................................................... 48

Figure 2.3. The conventional monetary policy transmission mechanisms summarised

................................................................................................................. 58

Figure 3.1. Evolution of key institutional frameworks of modern Islamic banking and
finance industry ....................................................................................... 62

Figure 3.2. The concept of money in the general methodological framework of Islamic
worldview ............................................................................................... 63

Figure 3.3. The breakdown of Islamic financial system ........................................... 74

Figure 3.4. A generic structure of sukuk ................................................................... 82

Figure 3.5. Total global sukuk issuances (Jan 2001 - Dec 2017) all tenors, all
Currencies, in USD Millions................................................................... 83

Figure 3.6. The general impact of interest-free based financial and monetary policy
................................................................................................................ 84

Figure 3.7. Showing cross-country comparisons of mechanisms for short-term

liquidity regulation amongst Islamic banks ............................................ 86

Figure 3.8. Showing both the international and national share of Islamic banking and
finance assets for the nine core markets ................................................. 92

Figure 3.9. An illustration of the contemporary Islamic financial system as practiced

in Muslim majority countries .................................................................. 97

Figure 3.10. The Contemporary Monetary System structure in Muslim Countries .... 99

Figure 3.11. Monetary policy transmission mechanisms under a dual economy...... 101

Figure 5.1. Comparison of economic growth of the Islamic system (profit and loss
sharing) and the conventional (interest-based system) ......................... 137
 xxii

Figure 5.2. The effects of expansionary monetary policy on real GDP under the
interest-free monetary system ............................................................... 139

Figure 5.3. An illustration of how government expenditure crowds out private

investment and reduces aggregate output under the interest-based financial
system ................................................................................................... 142

Figure 5.4. An illustration of how government expenditure facilitates private

investment and increases aggregate output to optimum level under the
interest-free financial system ................................................................ 143

Figure 5.5. An illustration of the optimal point at which the Islamic financial and
monetary system operates ..................................................................... 144

Figure 6.1. Histograms showing the distribution of each raw data variable for each
cross-section .......................................................................................... 164

Figure 6.2. Histograms of the data after being transformed into logarithms .......... 165

Figure 6.3. Histogram for each cross-section .......................................................... 166

Figure 6.4. Trends of the dependent variable for individual cross-sections under the
interest-free monetary system ............................................................... 167

Figure 6.5. Trends of the dependent variable for individual cross sections under the
interest-based monetary system ............................................................ 168

Figure 6.6. a under interest-free monetary policy aggregate (lifmp) ...................... 202

Figure 6.7. b under interest-based monetary policy aggregate (libmp)................... 202

Figure 6.8. a. Under interest-free monetary policy aggregate (lifmp) .................... 203

Figure 6.9. b. Under interest-based monetary policy aggregate (libmp) ................. 204

Figure 6.10. a. Under interest-free monetary policy aggregate (lifmp) .................... 204

Figure 6.11. b. Under interest-based monetary policy aggregate (libmp) ................. 205

Figure 6.12. a. Under interest-free monetary policy aggregate (lifmp) .................... 206

Figure 6.13. b. Under interest-based monetary policy aggregate (libmp) ................. 206

Figure 6.14. a. Under interest-free monetary policy aggregate (lifmp) .................... 207

Figure 6.15. b. Under interest-based monetary policy aggregate (libmp) ................. 208
 xxiii

Figure 6.16. a. Under interest-free monetary policy aggregate (lifmp) .................... 208

Figure 6.17. b. under interest-based monetary policy aggregate (libmp).................. 209

Figure 6.18. a. Under interest-free monetary policy aggregate (lifmp) .................... 210

Figure 6.19. b. Under interest-based monetary policy aggregate (libmp) ................. 210

Figure 6.20. a under interest-free monetary policy aggregate (lifmp) ...................... 211

Figure 6.21. b. Under interest-based monetary policy aggregate (libmp) ................. 212
 xxiv

LIST OF ABBREVIATIONS

AAOIFI Accounting and Auditing Organization for Islamic Financial Institutions

AD Aggregate Demand

ADF Augmented Dick Fuller

AEH Adaptive Expectation Hypothesis

AIC Akaike Information Criterion

APT Arbitrage Pricing Theory

ARDL Autoregressive Distributed Lag

ARMA Autoregressive Moving Average

AS Aggregate Supply

B.C Before Christ

BD Bank Deposit

CBI Central Bank of Iran

CBK Central Bank of Kuwait

CD Cross-section Dependence

CICs Central bank Investment Certificates

CII Council of Islamic Ideology

CIPS Cross-section I’m Pesaran and Perron

CMCs Central Bank Certificates

CPI Consumer price index

DH Dumitrescu Hurlin

DOLS Dynamic Ordinary Least Squares

DW Discount Window

ECB European Central Bank

EG Engel Granger

FMOLS Fully Modified Ordinary Least Squares

 xxv

FR Federal Reserve

GCC Gulf cooperation Council

GDP Gross Domestic Product

GFDR Global Finance Development Report

GFSR Global Finance Stability Report

GIC Government Investment Certificates

GMCs Government Musharakah Certificates

HQLAs High-Quality Liquid Assets

IBM Interest-Based Monetary system

IBMP Interest-Based Monetary Policy

IDB Islamic Development Bank

IFMP Interest-Free Monetary policy

IFS International Financial Statistics

IFSI Islamic Finance Services Industry

IIFM International institute of Financial Markets

IMF International Monetary Fund

IMP Islamic Monetary Policy

INFLNEX Inflation Expected

KFH Kuwait Finance House

KIBOR Karachi Interbank Offered Rate

KLIBOR Kuala Lumpur Interbank Offer Rate

KPMG Klynveld Peat Marwick And Goerdeler

LCPI Log of consumer Price index

LCR Liquidity Coverage Ratio

LIBOR London Interbank Offered Rate

LLC Levin, Lin and Chu

 xxvi

LM Liquid money

LOC Letters of Credit

LRR Legal Reserve Requirement

MB Monetary Base

MDF Money Demand Function

MP Monetary Policy

NAIRU Nonaccelerating Inflation Rate of Unemployment

OECD Organisation for Economic Cooperation and Development

OIC Organisation of Islamic Conference

OLS Ordinary Least Squares

OMO Open Market Operations

OPEC Organization of Petroleum Exporting Company

OPR Overnight Policy Rate

PBH Peace Be upon Him

PESCADF Pesaran Cross-section Augmented Dick Fuller

PLS Profit and Loss Sharing

PP Phillips-Perron

PSIAs Profit Sharing and Investment Accounts

QH Qardh Hassan

RBC Real Business Cycle

REER Real effective exchange rate

REH Rational Expectation Hypothesis

ROA Return on Assets

ROE Return on Equity

ROLA Return on Long-term Assets

SAMA Saudi Arabia Monetary Authority

 xxvii

SIC Schwarz Information Criterion

SMEs Small and Medium Scale Enterprises

SPV Special Purpose Vehicle

UAE United Arab Emirates

UN United Nations

UNGA United nations general assembly

USA United States of America

USD United States Dollar

USD United States Dollar

VAR Vector Autoregressive

VIBMP Velocity for the interest-based monetary aggregate

VIFMP Velocity of the interest-free monetary aggregate

WEF World Economic Forum

WIR World Inequality Report

 1

INTRODUCTION

Monetary economics constitutes the oldest and the most paramount segment of
macroeconomic literature, whose documented history dates to the Greek generations
(O’Brien, 2007). It focuses on the central bank functions and roles such as money supply,
financial markets and inflation rate management and how they affect the different units
of an economy (Handa, 2009; Mathai, 2009). To be able to effectively pursue and achieve
its monetary policy goal of sustainable price and financial stability (Tapşin, 2019), central
banks require a well-specified and comprehensive money demand function (Öztürk &
Acaravci, 2008; Uddin, 2016). Moreover, in building macroeconomic theory, the
relationship between the demand for money and its determinants, forms the single most
paramount building block and critical component in the conduct of monetary policy
(Goldfeld, 1994). Therefore, expectedly, in both developed and least developed
economies, the demand for money continues to attract the utmost attention as a very
important topical issue than any other in macroeconomic discussions (Gerlach &
Svensson, 2001).

In the conventional monetary literature, there has been a considerable number of studies
that investigated and tested the stability of the money demand function including
(Halicioglu & Ugur, 2005) for Turkey, (Korap and Saatcioglu, 2005) for Turkey, (Gencer
and Arısoy, 2013) for the Turkish economy, (Baharumshah et al., 2009) for China, (Atta-
Mensah, 2018; Capasso & Napolitano, 2012) for Italy, (Bahmani-oskooee &
Economidou, 2005) for Greece, (Valadkhani, 2017) for Taiwan, (Valadkhani, 2017) for
Asian-pacific economies, (Bakhouche, 2006) for Algeria, (Akinlo, 2006) for Nigeria,
among other works. In contrast, very few of such studies have been undertaken from the
Islamic viewpoint and much less in the case of dual financial economies. Thus, the
hypothesis that the Islamic monetary and financial system is superior, effective, efficient,
 2

and more stable as compared to its conventional counterpart has largely remained
theoretical.

The few notable empirical studies that have compared the interest-free and interest-based
monetary and financial system could not find conclusive collaborative evidence for and
or against the hypothesis. These include Darrat (1988) who affirmed the stability and
therefore superiority of an interest-free over the interest-based system based on Tunisian
economic data series, a country that had no history of Islamic banking and finance at the
time, Hassan and Aldayel (1998) who investigated and compared the behaviour of the
money demand function under the interest-free and interest-based financial systems in
fifteen Muslim countries. They found mixed results and recommended a cointegration
regression study for a conclusive inference to be made.

In other studies, Yousefi et al., (2010) investigated the Iranian economy before and after
implementing a full-fledged Islamic monetary and financial system to assess the
superiority based on the stability of the money demand function. They also found mixed
results with some evidence for and against the hypothesis of existence of greater stability
in an Islamic monetary economy. They consequently recommended for more research in
the area. Kia and Darrat (2007) study on Iran re-affirmed the stability of an Islamic
monetary system. Lastly Awad and Soliman (2016) study compared an Islamic financial
against the conventional one in terms of the stability of the money demand function and
confirmed the superiority of the Islamic over the conventional financial system. The most
common recommendation across these studies has been a call for more empirical
investigation as regards the money demand function under an Islamic monetary and
financial environment. This study thus has been undertaken to try and close this gap in
literature.

This study therefore aimed at testing the hypothesis that central banking and monetary
policy management from the Islamic perspective is more effective, efficient, and superior.
The study examined this superiority by comparing; i) the stability of the money demand
function, stability in the variance of velocity of money (interest-free versus interest-based
monetary aggregates), and the strength of the correlation between the monetary
aggregates and the monetary base as well as price (as the main goal of monetary policy)
and the monetary aggregate in eight Muslim majority dual economies with consistent data
variables.
 3

These countries were chosen based on the World Economic Forum (WEF) as indicated
by Ernst & Yung (2015) study that considered them the leading countries in the
implementation of Islamic banking and finance practices. Following their order of total
global share of Islamic assets as indicated in brackets, they include Saudi Arabia
(31.70%), Malaysia (16.70%), Kuwait (10.50%), Qatar (7.70%), Turkey (5.80%),
Indonesia (3.80%), Bahrain (1.70%), and Pakistan (1.20%). United Arab Emirates was
dropped from the list for lack of consistent data on the necessary variables as per the study
period.

Our study consisted of six chapters. Chapter one basically lays down a brief background,
statement of the problem, motivation, general and specific objectives, contributions,
significance, organisation, and limitations of the study. Chapter two and three takes an
overview of the monetary and finance systems for both the conventional and Islamic
system, one after another. We looked at the historical evolutions of each system, money
and its functions, strategies, aims, targets and objectives of central banking and monetary
policy, the roles and functions of the central bank, the monetary policy tools, the theory
and history of interest rate, monetary policy transmission channels, comparison of the
Islamic, the contemporary Muslim majority practices and the conventional monetary and
financial systems. Lastly, differentiating between the Islamic monetary and financial
system and its conventional counterpart.

Chapter four surveys the related literature and identifies the gaps that this study seeks to
close as already mentioned. Chapter five looks at the epistemological foundations that
underpins the superiority of the Islamic over the conventional monetary system based on
theoretical setup and divine postulations a mention in the Holy Quran, Bible, Torah and
in the different traditions of Prophet Muhammad peace be upon him (PBH). The
macroeconomic theories of the money demand function and inflation-output discussions
of the conventional system are compared with the Islamic one before illustrating how the
Islamic monetary and financial system facilitates the achievement of macroeconomic
goals, monetary policy ones inclusive in a more effective way than the interest-based
system.

Chapter six empirically regressed the long-run cointegration of money demand and its
determinants using panel dynamic ordinary least squares (DOLS), panel fully modified
ordinary least square (FOLS) and short-run relationship using a bound autoregressive
 4

distributed lag (ARDL) model for the time series estimation. The study data, secondary
in nature, was collected from the International Monetary Fund (IMF), International
financial statistics (IFS), and the World Bank. It spans from 1991-2016 inclusive, making
a total of 26 observations for eight cross-sections considered and categorized as leading
in the implementation of Islamic banking and finance as stated in the World Economic
Forum (WEF) by Ernst & Young (2015).

In the presence of endogenous regressors, panel DOLS and FMOLS estimators are hailed
for producing unbiased estimates for cointegrated variables especially where
contemporaneous correlation has been detected in the data set. These panel techniques
also can correct the long run cross-section dependence and serial correlation problems
associated with panel datasets among cointegrating equations as well as among stochastic
regressors (Carlsson et al., 2007; Dreger et al., 2007; Saikkonen, 1992; Stock & Watson,
1993). More importantly, under cointegration regression, the DOLS estimator is super-
consistent and especially robust not only to the omission of variables that do not form
part of the cointegrating relationship such as interest rate but also reducing the bias
associated with small sample size as the case in our study (Masih & Masih, 1996;
Sloboda, 2004). Considering the two panel estimators together produces robust results
with appropriate inferential statistics. This justifies our choice for the long-run panel
methodologies employed.

As for the bound ARDL model, our justification for employing it on the short-term
estimations was underpinned by two factors; i) it takes care of both stationary and non-
stationary variables in the model such as the expected inflation rate and the real income,
respectively and, ii) it provides decisive interpretation of the results based on the tabulated
two sets of appropriate critical values (Pesaran et al., 1996).

We employed robust panel cointegration methodology techniques including Pedroni

(1999, 2000, 2004), Kao (1999, 2000, 2002), and a fisher-type test based on underlying
Johansen (Maddala &Wu, 1999) to test for the presence of cointegration relationships
among the variables of the study. However, aware that cointegration could sometime be
because of the existence of a strong relationship among some of the variables but not all
the variables, we first undertook the cointegration regressions to determine which
variables are insignificant and do not belong to the cointegrating space before analysing
and comparing the stabilities in the demand function and velocity.
 5

The first panel data regression findings revealed three main takeaways: i) re-affirmed the
existence of cointegration between the dependents and the independent variables
considered in our money demand functions, ii) indicated that that expected inflation as an
independent variable is more important under the Islamic monetary economy compared
to the conventional one and lastly, iii) although both models seem to be stable with
coefficients of the scale variable and opportunity cost variable carrying the expected
signs, the model in which the interest-free monetary aggregate is specified performs better
since all the variables do not only possess the expected signs but are also statistically
highly significant than the one of interest-based monetary aggregate. Therefore, from the
panel data results standpoint, ceteris paribus, the countries under study ought to target M1
(proxy for interest-free money) for a more effective and efficient monetary policy
management.

The other main findings from the empirical section on comparison of the relative stability
of the money demand function for both interest-free and interest-based monetary
aggregates, apart from the Indonesian plot of cumulative sum of squares for the recursive
residuals’ tests of both IBMP aggregate, and Kuwait IFMP, that exhibit transitional drifts
from the critical areas, all the other plots show that both models are indeed relatively
stable since they lie within the 5% critical region. The relative stability suggests that when
interest rate does not make part of the cointegrating variables, the demand for money is
relatively more stable. Therefore, whereas we could not find compelling / overwhelming
evidence underpinning or in support of the earlier stated hypothesis, one thing is clear,
central banks in dual financial and monetary environments should start shifting their
attitudes from the prohibited policy rate towards adopting money supply in monetary
policy management (Poole, 1970, 2006). Our study results on the stability of the money
demand function under the interest-free financial system collaborate Hassan and Aldayel
(1998) study findings who analyzed the behaviour of demand for money under interest-
free and interest-based financial systems in fifteen Muslim countries.

Also, the ultimate implication drawn from the quantity theory of money is that if an
increase in money supply is to be transmitted and or to interpreted to mean an increase in
prices or production, the velocity of money must be predictable or stable. Since velocity
epitomises the relation between money, price level and the level of output, testing for the
stability of velocity is normally reduced to testing for the stability of the linear
 6

relationship between the explanatory and the dependent variables in the money demand
function (Bahmani-Oskooee & Karacal, 2006). So, on comparing the variance of velocity
for the monetary aggregates under the two monetary systems, our findings are quite
variant and clear between the two monetary aggregates (1.14) versus (5.20) for interest-
free money against interest-based money, respectively. These results are quite consistent
with theoretical postulations in the Islamic monetary literature; money with no interest is
moreless volatile as compared to money with interest that is anchored on speculations
based on interest rate differentials in different areas.

On testing the two monetary systems on their ability to effectively pursue monetary
policy, we tested each monetary aggregate on the two pre-conditions suggested by Batten
and Thornton (1983) including i) the monetary aggregate has to be under the direct and
full control of the central bank; ii) there has to be a strong and reliable cointegration
between the monetary aggregate and the main goals of the monetary authority. The
monetary authority possesses direct and full control only on the interest-free monetary
aggregate. This is anchored on the existence of the 100% reserve requirement and absence
of the fractional reserve ratio. So, commercial banks under the Islamic monetary
arrangement cannot create derivative money and hence the relative financial stability.
Comparing the correlation between the interest-free monetary aggregate and the monetary
base as well as the link between the main monetary policy goal (price stability) and the
monetary aggregates, the interest-free monetary aggregate exhibited a relatively stronger
link compared to its interest-based counterpart.

The study also confirmed that no single country has implemented Islamic monetary policy
as guided by the Holy Quran and hadiths of the Prophet (PBH) perhaps due to the virtual
absence of formal descriptions in many of the proposed Islamic monetary theories (Khan
& Mirakhor, 1994). All the eight countries of the study, despite being hailed as leading
in Islamic banking and finance, their monetary policy is anchored on the conventional
system including the policy interest rate, fiat money, and fractional reserve requirements
that enables commercial banks to create derivative money and foster inflation tendences
among other practices. So, it is hoped that our findings on the relative stability of the
money demand function that is modelled without the prohibited interest rate variable can
increase and improve on their confidence towards a genuine Islamic monetary and
financial system.
 7

The Islamic finance products being used not only have their ratios such as profit and loss
sharing ratios benchmarked on the rates of interest, but also their usage tends to mimic
those of the conventional banking sector (Al-Jarhi, 2016). For as long as the central banks
in countries that are implementing Islamic banking and finance continue to mimic their
conventional counterparts especially in the field of monetary policy regulation,
benchmarking their profit ratios on the interest rate charged in the conventional system,
the maqsid shari’ can never be realised. Therefore, monetary authorities ought to
gradually shift their mind-set from the interest-based monetary operation to an interest-
free system under a dual monetary arrangement as a fundamental step towards a genuine
Islamic monetary system.

Lastly, our study findings are hoped to augment the belief and provide more confidence
to monetary authorities in both these countries and even in others to trigger a mindset and
gradual practical shift towards the Islamically acceptable monetary policy tool by
replacing the policy rate with money supply.
 8

CHAPTER ONE

1.1. Introduction

This section covers the background to the study, statement of the problem, aims and
objectives of the study, research questions of the study. significance of the study,
contributions of the study, scope, and limitations of the study and lastly organisations of
the study. The details of these sub-sections are briefly explained as follows.

1.2. Background of the study

Historically, monetary economics constitutes the oldest part of economic literature with
its footprints stretching as far back as the Greek generations (O’Brien, 2007). It focuses
on the economics of money supply, financial markets and how it affects the different units
of the economy (Handa, 2009). Monetary policy in conventional terms is always
connected with the functions and roles of the central bank in its pursuit to regulate money
supply and inflation levels in an economy (Tümtürk, 2017; Mathai, 2009). Being a
relatively new discipline in the modern sense, central banking and monetary policy
management through the Islamic monetary policy instruments is quite challenging (Efe,
2018). This is attributed to its being a much broader concept than it is in the conventional
monetary sense (Chapra, 1983, 1985, 1996).

However, if systematically handled, the overriding hypothesis across Islamic monetary

literature is that it is more effective and efficient in accelerating the achievement of both
monetary and macroeconomic goals of any economy (Hossain, 2009; Kammer et al.,
2015). So, owing to its vital role, it forms the most critical subset of any economic system
since it is the main segment by which governments stabilize the economy. Monetary
policy is conducted by the central bank to influence the overall performance towards the
achievement of pre-stated targets. This is aimed at improving the overall wellbeing of
 9

humanity, at least from the Islamic perspective. To achieve their respective economic and
monetary targets, governments rely on the operations of the monetary authorities which
are in most cases, the central banks.

In a bid to be successful in its operations, the central bank of any country requires
comprehensive money demand function (MDF) estimations to determine and predict not
only the amount of money required to ensure adequate liquidity for a sustainable price
and financial stability in the economy but also to identify the most appropriate monetary
policy tools necessary for its target achievement (Tümtürk, 2017). The monetary
authority determines the adequate money supply level based on the demand for money at
full employment level (Chapra, 1996).

Therefore, without a stable money demand function1, monetary targeting regime which is
prime to the achievement of price stability as the primary goal of monetary policy under
the Islamic monetary system cannot be employed2 (Özcan and Arı, 2013). In other words,
monetary authorities decide the right amount of monetary expansion that accelerates
economic growth towards the optimal level on the basis of the estimated parameters of
the money demand function (Doguwa et al., 2014; Kia & Darrat, 2007; Poole, 2006). So,
properties of the money demand function in any economy must take centre stage for
monetary policy implementation to be successful (Bain & Howells, 2003; Goodhart,
2013; Laidler, 1999, 1982, p. 39). Some countries abandoned monetary targeting for
inflation targeting strategy in the 1980s on allegations of instability of the money demand
function (Boughton, 1981; Goldfeld,1976).

Monetary policy as it prevails in the world today has evolved over a very long period.
Undoubtedly, the conventional monetary system forms the main monetary policy
practiced in the contemporary world. Nevertheless, the robust success that Islamic finance
and banking registered particularly in the last three decades has given impetus to
contemporary economists to think of the Islamic monetary policy as an alternative to the
perpetually failing contemporary system (Ahmad, 1994). Besides, under the Islamic
economic system, the hypothesis is that money demand is regulated by instruments that

1
Anderson (1985) outlines three main sources of money demand instability; (i) changes in the velocity of
circulation, (ii) shifts in the money demand function itself in response to fluctuations in the interest rate and
(iii) over shorter periods, the held money stocks may not correspond to the desired money balances.
2
According to Poole (1971), where a stable money demand function exists, the central can employ money
supply as an effective monetary policy tool.
 10

promote greater efficiency and equity in the use of money. As a result, there is a relatively
greater stability in the demand for money in an Islamic economy. This may equally
produce greater stability in the velocity of money circulation (Chapra, 1992, 1996).

It should be noted that there was no Islamic banking (in the form we have today) during
the time of the Prophet (PBH) in the then Islamic state in Medina. Loans were offered by
money lenders who charged interest that would be doubled and multiplied in case of
failure to pay on the scheduled time periods and in the worst cases, defaulters’ personal
properties including family members could be attached (Erdem, 2017; Sadr & Sadr,
2016)3. Pretty much like many conventional banks and money lenders do today, the then
moneylenders also contended that their practice of usury was not any different from
“normal” trade. However, Allah dismissed their claims in the following verse of the Holy
Quran:

“… that is because they say: ‘Trade is like usury’ But Allah has permitted trade and
forbidden usury …” Surat al-Baqarah (275).

As for monetary management, it was the duty of Bait al mal (State treasury) to supervise
and ensure that all imported coins and the minted ones for money supply were up to the
required quality and standard. To determine the exchange rate, the Prophet peace be upon
him (PBH) is reported to have provided guidance in a famous hadith4 by Ahmad and Al
Bukhari as follows.

“Gold for gold, silver for silver, wheat for wheat, barley for barley and salt for
salt, in equal weight and hand to hand, whoever increases or asks for an
increase falls in riba; the taker and the giver alike” (Saadalla, 1994).

In a bid to ensure justice and preservation of human dignity in society, Islam prohibited
usury (loosely translated as interest rate) practices (Hassan, 1999)5. The Quranic

3
This type of interest rate charge was known as riba al-jahiliyyah and was deep-rooted in the Pre-Islamic
Arabia.
4
Hadith is second to the Holy Quran as source of Islamic law and moral guidance. It refers to the collection
of all traditions (sayings, acts, approvals, and disapprovals) attributed to Prophet Muhammad Peace be upon
him (PBUH) but excluding his physical appearance (Phillips,2007).
5
The prohibition of riba followed a gradual process like that of intoxicants. This process took place in 13
different verses of the holy Quran that broadly came down (nuzuur) in four phases. In the first phase, the
practice was simply discredited for example (Al-Ruum, 39). In the second phase, believers were warned
against the practices as seen in verses such as (Al Nisa, 160-161). In the third phase, riba was banned with
 11

prohibition of interest rate and the numerous traditions of the Prophet emphasizing this
prohibition guided the Islamic scholars at that time and throughout the subsequent Islamic
states to develop comprehensive rules and regulations governing economic activities
without interest rate charges. This prohibition is derived from two axioms: mutual
fairness in business dealings and a reflection of actual reality (Khan & Bhatti, 2008). This
practice continued throughout the golden age of Islamic development to the early periods
of the last Islamic empire, the Ottomans (Blake, 2002)

During the 17th century, the first modern bank was established in Italy but was based on
the practice of interest rates (Quinn & Incla, 1997). Today, this practice has become the
mainstream in the financial services sector including in the Muslim world. Since the
1940s, Muslim scholars have endlessly and vigorously embarked on the development of
products that resemble the products offered in the conventional banks but only charge
commissions for the service rendered and base on equity-participation modes when
extending loans to their customers (Beck et al., 2010). The implementation of these ideas
culminated into the emergence of Islamic banking in the form we have today. However,
despite a fast-growing industry, the implementation of Islamic monetary policy has not
received as much attention.

1.3. Problem Statement

The central bank operations are aimed at achieving price stability by using monetary
policy instruments and financial stability by using macro-prudential tools (Erdem et al.,
2017). Once achieved, those primary goals facilitate the attainment of other
macroeconomic goals of any economy in a sustainable manner. According to the United
Nations General Assembly report (2011), any economic policy, monetary or otherwise is
measured by evaluating its effectiveness towards improving the happiness of the people
and their general wellbeing. The conventional central banking and monetary policy is
inherently prone to economic crises and therefore fails the UN standard (Kameel et al.,
2004). The need for a monetary policy framework that provides for greater stability in

wordings as stated (Aal Imran, 130-132). Towards the end of the revelation, the last phase of verses
prohibited riba in very strict terms for example (Al Baqarah, 275-281), (Erdem, 2017; Karaman et al.,
2006).
 12

financial markets and the general economy is inevitably justified (Askari et al., 2012;
Sakarya & Kaya, 2013, p. 6; Iqbal & Mirakhor, 2011).

Historically, all documented major economic problems such as the great depression
1929-1933, the great moderation 1987-2002, the disinflations 1979-1982 in between
through to more recently the global economic meltdown of 2007 – 2008 have in one way
or another been caused by the inefficiency inherent in the debt-based monetary system6.
This is because interest does not only allow monetary expansion at the expense of the real
economy, but also inherently limits the full employment of capital (Ahmad, 1994)

Upon the occurrence of every major economic and financial crisis, renewed regulations
regarding deposit insurance, regulation of securities, and the supervision of banks have
seen some improvements in monetary policy performance. However, the continued
reoccurrence of such major economic and financial instabilities that keep compromising
the happiness and general welfare of majority taxpayers serves to re-affirm that the actual
cause of monetary and financial instabilities is yet to be addressed. Therefore, relentlessly,
research efforts to reach a lasting solution that can ensure more effectiveness of the central
banking and monetary policy operations and possible alternatives is justifiable.

Most recently, financial, and economic analysts have revealed that at the advent of the
global financial crisis, it was the failure of the interest-based monetary policy to regulate
the money market that consequently resulted into the global financial and capital market
meltdown in 2007-2008. As a result, central banks particularly the European Central Bank
(ECB) and the Federal Reserve (FR) resorting to unconventional measures in their efforts
to address gaps to prevent a fully blown out financial break down in the global system.
To the surprise of many, while the rest of the world was experiencing a global financial
slow down, the growth rate in the Islamic financial sector remained steady at an annual
percentage of around 17% (IFSB, 2015). So, the global economic meltdown did not only
demonstrate the inability of the traditional monetary policy framework to ensure
sustainable financial and economic stability, but also exhibited the superiority and
resiliency of the Islamic based system during economic shocks.

6
For more details, see Sargent, “The End of Four Big Inflations,” in Rational Expectations and Inflation
(New York: harper and Row, 1986).
 13

Therefore, it isn’t surprising that since 2009, renewed intense collaborative efforts have
focused on reaching out to financial reforms that can ensure a sound and resilient
sustainable monetary and financial system as an alternative that is less vulnerable to
financial crisis (Demiralp, 2015, p. 5; Apaydın, 2015, p. 44; Aziz, 2010). Specifically,
recent literature suggest that there is a growing consensus of ideas that Islamic banking
and finance-oriented financial institutions make open economies more resilient to shocks
since equity- based banking systems cope better than the main stream debt-oriented
systems particularly when an economy comes under pressure such as demonstrated
during the most recent global economic meltdown of 2007-2009 (Hasan & Dridi, 2010).

According to the noble prize winner, Maurice Allais to avoid reoccurrence of financial
predicaments, economies ought to make structural re-adjustments to bring interest rate
down to 0% (Elasrag, 2012). Maurice Allais’s advice serves to augment what Islamic
economics scholars have stressed for a long time on the critical role of an interest-free
monetary policy as a foundation for the proper functionality of any economic and
financial system. Stressing this significance, some scholars argue that a whole new
monetary system should be developed instead, rather than developing something as part
of the existing system (Erdem, 2017)

For example, Hassan and Aldayel (1998) study argues that monetary policy in the Islamic
framework should play a vital role in establishing sustainable financial stability and
growth. The prohibition of interest as the key fundamental pillar upon which Islamic
economics is based, makes the instruments and mechanism of the Islamic monetary
policy superior and different from the conventional economic that dominates the world
today. They further argue that since Islamic economics presents an alternative system
within; practical solutions are required so that the monetary policy aspects of Islamic
banking can be accommodated.

However, despite the enormous efforts to re-align the banking sector towards the Islamic
banking principles especially since the early 1980s, the central banking and monetary
policy operations have largely continued in the traditional framework including those of
Muslim countries (Beseiso, 2016). So, with all the above documented economic and
financial failures in the conventional monetary system, the several attempts to improve
not withstanding central banks across the globe continue to rely on conventional interest-
based monetary system which is prone to financial instability and economic crisis.
 14

The case in point is that despite the remarkable developments that show emphatically that
Islamic banking and finance is now a very high-profile topic as expressed in the different
working papers released about financial inclusion, which is the new policy and target for
the World bank for 2014–2020 global financial development report (GFDRs, 2014),
central banks including in the Muslim majority countries are still reluctant to implement
Islamic monetary policy. Therefore, the need to theoretically and empirically examine the
superiority and viability of monetary policy management in the Islamic perspective
remains crucial and this study seeks to feel this gap in literature.

1.4. Aims and objectives of the study

Considering the most recent global economic crisis, there has been increased interest in
the quest for an alternative monetary policy with many economists developing more
interest in the Islamic monetary system. However, the absolute prohibition of interest rate
in all its facets by the shari’ (Islamic law) has seen disagreements among different groups
of Islamic economists with some arguing that interest rate especially to the central
government (public good) loans is acceptable while others maintaining that its
unacceptable.

Thus, although many Muslim majority countries are increasingly choosing to bring their
banking and financial systems in accordance with the rules prescribed by Islamic law;
including restructuring their operations to conform to the restrictions on interest-free
financial transactions, nearly all have continued to technically base their operations on
conventional economic systems since the central banks across such countries continue to
operate under the conventional monetary policy frameworks. This is confirmed by the
fact that many central banks and commercial banks practicing Islamic banking set their
benchmarks based on the London interbank offered rate (LIBOR), a practice that has
raised questions and sometimes controversy on the uniqueness of the Islamic finance.

In Muslim majority countries like Turkey with dual banking systems where Islamic
finance is not yet fully developed, and even countries where Islamic banking and finance
exhibits much more growth levels like Malaysia and Saudi Arabia, there is continued
reliance on the conventional system (Ashraful et al., 2014). For example, Islamic banks
tend to rely on conventional interest rates to price their murabahah and ijarah contracts
among other products in Malaysia, profit rates in Islamic banks have always been pegged
 15

close to the conventional deposit rates bank (Negara Malaysia Monthly Bulletin, 2013).
So, despite renewed interest in the field, the available literature indicates that there is
limited empirical work on the alternative Islamic monetary policy frameworks that
Islamic economic system can be based on as a sustainable alternative to the conventional
monetary system (Uddin, 2016).

Most of the studies on Islamic finance and banking largely focus on the development of
shari’ compliant products according to the Islamic principles. In fact, from the available
literature, there is general lack of research interest in the field of Islamic monetary policy
perhaps because it is still a new discipline in the economics literature (Yusof et al., 2009).
Currently, there are very few modern scholars who have showed interest on deliberations
concerning the guiding principles of Islamic monetary policy.

If the main policy governing Islamic banks is based on interest rates LIBOR in majority
Middle Eastern countries and KIBOR (Karachi Interbank Offered Rate) in the case of
Pakistan, it is difficult to expect Islamic banks to achieve the objective of shari’ (maqsid
al shari’). In fact, some studies that find no fundamental distinction between the Islamic
banks’ performance are precisely because benchmarks used in these banks are in most
cases based on the interest rates in the conventional monetary system.

The main aim of this study therefore is to assess the relative superiority and effectiveness
of an Islamic monetary system over its conventional counterpart based on the stability in
the demand for money, variance of velocity of money and the central bank control and
authority on the monetary aggregates. The study particularly focuses on eight Muslim
majority countries with the highest share of Islamic finance assets (Ernst & Young,
2015)7.

The distinguishing features of these countries hinges on the fact that some of them (for
example, Malaysia) are implementing a dual-financial system in which monetary policy
is managed through the Islamic banks using sharia-compliant monetary policy tools and
the conventional ones using conventional monetary policy instruments. While others like
Turkey have established enabling financial regulations to facilitate the setting up of both
fully-fledged Islamic banks and Islamic windows inside conventional bank (Awad, 2015).

7
United Arab Emirates came next to Malaysia with a global Islamic finance banking share amounting to
14.60%. However, it has been dropped from the empirical analysis of this study because it lacks consistent
data for some of the variables considered by the study.
 16

They include Saudi Arabia (31.70%), Malaysia (16.70%), Kuwait (10.50%), Qatar
(7.70%), Turkey (5.80%), Indonesia (3.80%), Bahrain (1.70%), and Pakistan 1.20% as of
2015. These are illustrated in the following figure:

Figure 1.1. Showing Global Share of Islamic Finance Assets

Source: Ernst &Young (2015)

It is in the interest of every government to understand the money demand function of her
economy so that she can precisely predict the likely effects of changes in money stock to
the key demand variables such as real income and prices (Blanchard and Fisher, 1989,
p.569; Laidler, 1993, p.187, 1999). Owing to its significance8, estimations of the money
demand function dominates applied economics literature as the leading topic in many
countries (Harb, 2004). Therefore, the main analysis of this study is based on an
examination of the money demand function as a key determinant for the success of
monetary targeting regime9, pursued by all Islamic central banks. Specifically, we
examine the money demand relative stability, relatively stability of variance of velocity

8
McCallum and Nelson (2011, p.101) states the implication of the Fisher’s Quantity Theory of Money as
follows: One of the relations in any complete model for a monetary economy is a demand function for real
money balances. One condition for the long-run monetary neutrality to prevail is that this function must
relate to the demand for real balances only to variables).
9
The success of monetary targeting regimes hinges on two basic assumptions; (i) a predictable money
velocity (i.e. the relationship between the monetary target and the goal variable should be strong enough)
and (ii) a predictable money multiplier (i.e. the strong bank must have full and direct control over the
monetary aggregate) (Batini et al 2005).
 17

of money and the correlation between the monetary aggregate and the monetary base and
lastly the link between price and the monetary aggregates.

By definition, demand for money refers to the proportion of one’s wealth that is held in
liquid form to enable him or her to make payments. It is sometimes known as liquidity
and or liquidity preference (LM). From the quantity theory of money, velocity of money
circulation is defined as the number of times a unit of money is used for settling
transactions over a specified period (Fisher, 1911)10. Money velocity is an important
element inn monetary policy management. To put it differently, to be effective in their
monetary policy management, the monetary authorities ought to be able to have full
control monetary growth. But without a relatively stable or at least predictable velocity
of money and its variance, central banks cannot effectively and efficiently use money
supply to influence the economy towards the desired goals (Hassan, 1998). This
underpins the crucial role that velocity of and its variance plays in monetary policy
management.

Velocity of money is the inverse of money demand as traced back in the Fisher’s equation
of exchange as stated (V = Y/M), where; V= Velocity, Y= income and M = money stock.
Much as the velocity of money is very had to predict especially over the short-term, it can
easily be determined by examining the demand for money and the supply quantity of
money. In other words, the demand for money can be tested as a proxy for the stability of
velocity. The stability of the money demand function in this study is tested using the
CUSUM and CUSUM SQ. All these, however, depend on the existence of a very strong
link between the monetary aggregate and monetary base, the central bank’s full and direct
control over the monetary aggregate as well as the strong link between the monetary
authority goal and the monetary aggregate (Batten and Thornton, 1983).

Thus, the specific objectives for this study are stated as below.

1. To examine the cointegrating regression between the Islamic money demand

function (interest-free) and the conventional money demand function (interest-
based).

10
For more details, Friedman and Schwartz, A monetary history of the United States 1867-1960 (Princeton,
N.J.: Princeton University Press of NBER, 1963).
 18

2. To assess the stability of interest-free money demand versus the stability of

interest-based money demand in the selected Muslim majority countries.
3. To examine the view that the velocity of interest-free money is relatively more
stable than the velocity of interest-bearing money in the selected countries.
4. To analyse the view that the correlations between interest-free money and
monetary base as well as the link between the ultimate monetary policy goal and
the monetary aggregate is stronger compared to that of the interest-based
monetary system.

1.5. Research questions of the study

This study was guided by both general and specific research questions in the quest to
realize the aims and objectives explained above. To contextualize the study, an
understanding of the economies under study is crucial. The general question of the study
is to assess whether the Islamic monetary policy is a viable alternative to the conventional
monetary policy both theoretically and empirically based on the stability in the money
demand function, variance in velocity and monetary authority control over the monetary
aggregate. The general question includes.

1. What is the theoretical basis and foundation of an Islamic monetary system?

2. Is there a long and short-run relationship between interest-free money and its
determinants among the selected eight Muslim majority countries?
3. Is the demand for interest-free money (Islamic) more stable than the interest based
conventional money?
4. Is the velocity of interest-free money more stable compared to the velocity of
interest-based money in a dual financial system?
5. Does the Islamic monetary system offer more superior and effective solutions to
the stability of an economy?

There three specific research questions that this study will seek to answer considering the
above broad-based questions. These specific questions include.

1. Is an interest-free money demand more stable compared to the stability of interest-

based money demand in the selected Muslim majority countries?
 19

2. Is the velocity of interest-free money more stable than the velocity of interest-
bearing money in the selected countries?
3. Is the correlation between interest-free money and monetary base is stronger
compared to the correlation between interest-based money and the monetary base
in respect of the countries under study?

1.6. Significance of the study

Upon adequately investigating, analyzing and answering both the general and specific
research questions above, this study is hoped to inform and help policy-makers design
enabling policies for the central bank authorities for both these countries and all over the
world to quickly adopt. The study further has shed some light on how the interest-free
financial system provides solutions to the perpetual problems embedded in the
conventional system. The study tries to help Muslim governments to acknowledge and
embrace the fact that in a dual banking system where there are both conventional and
Islamic banks, the monetary policy should be designed in such a manner that it is a two-
fold system for both conventional and Islamic financial institutions as opposed to
duplicating or even straight forward following of the conventional benchmarks as it is
today. The study further helps readers to clearly distinguish between the conventional and
Islamic monetary policies in terms of the philosophy behind the two systems and in the
operation aspects. This study adds significantly on the scanty literature as regards
empirical works on the alternative monetary policy provided from the Islamic viewpoint.
Lastly, the study is hoped to enable the researcher to qualify for the award of a Ph.D in
economics since it is a partial fulfilment to this award process.

1.7. Contributions of the study

The reviewed literature showed that most of the studies that have tried to assess the
superiority of the Islamic monetary system over the conventional system especially based
on the stability of the money demand function, employed basic econometric models such
 20

as Ordinary Least squares (OLS)11, whose estimation results are in many cases associated
with biases.

My contribution in this study is of threefold: (i) to go a step further to explore the theory
of cointegration as recommended by Hassan and Aldayel (1998) to test the relative
stability of the money demand function for the interest-free monetary system versus
interest-based one using advanced cointegrating panel fully modified ordinary least
squares (FMOLS) and the Mark and Suk (1999, 2003), panel dynamic ordinary least
squares (DOLS) estimators (Phillips and Moon, 1999; Pedroni, 2001; and Kao and
Chiang, 2000). Bound ARDL approach for the short-run co-integration regressions on the
eight Muslim majority countries, (ii) to replace interest rate with expected inflation12 in
the regression analysis, (iii) to stress the crucial significance of a stable money demand
function as a prerequisite for an effective and successful monetary policy action.

The selection of these countries is based on Ernst & Young (2015) study in which the
eight Muslim majority countries are considered among the nine at the forefront in the
implementation of Islamic banking and financial practices is outlined. Compared to
earlier studies on the subject such as that of Darrat’s (1988) study on Tunisian economy
which had no record of Islamic banking at the time of the study, the data variables from
these countries are more reliable and authentic. Therefore, comparatively, other factor
kept constant, inferences from this study are likely to gain general acceptability. This
justifies our basis for choosing these eight countries since they represent an interesting
special case among the economies of the Muslim world.

In many econometric modelling literatures, these models are considered the most
appropriate and efficient in the analysis of the relationship between the variables in which
contemporaneous relationships are detected. For example, a study by Hlouskova and
Wagnar (2010) points out that the panel DOLS estimator outperforms all other single-
equation estimators as well as system estimators for large samples. Besides, under

11
Some of those studies include M. Kabir Hassan Adnan Q. Aldayel, (1998), stability of money demand
under interest-free versus interest-based banking system, Humanomics, Vol. 14 Issue 4 pp. 166 – 185,
Darrat, Ali F. The Demand for Money in Some Major OPEC Members: Regression Estimates and Stability
Results, Applied Economics, February 1986, pp.127-142.
12
Various studies have recommended expected inflation rate as a better measure of opportunity cost of
holding money as compared to the interest rate (Wong, 1977; Arize et al,1999). According to Baba et al.,
(1992), a money demand function in which inflation rate is omitted will likey produce spurious results.
Also, most importantly, interest rate has no productive role in an economy under the Islamic system.
 21

cointegration regression, the panel DOLS estimator is super-consistent and especially

robust not only to the omission of variables that do not form part of the cointegrating
relationship such as interest rate, but also reducing the bias of small sample size as the
case is in the this our study (Harris and Sollis, 2003; Masih & Masih, 1996).

These two approaches are specifically recommended when the panel data possesses
contemporaneous correlation among some of or all the units of the cross-section set. The
two methodologies combine nonparametric approaches and white heteroskedastic
standard error terms to produces robust estimates (Arize et al., 2015; Osang and Slottje,
2000). Besides, while the FMOLS estimator produces robust results that are
asymptotically unbiased, the DOLS estimator eliminates feedback in the cointegrating
regression by including leads and lags of the explanatory variables which clears long-run
dependence problems, thereby producing asymptotically efficient results (Saikkonen,
1992; Stock & Watson, 1993; Dreger et al., 2007; Carlsson et al., 2007).

1.8. Scope and limitations of the study

This study focuses on the eight Muslim majority countries that have been designated as
leading in the implementation and operations of Islamic banking and finance according
to Ernst and Young (2015). These countries stand out as most appropriate especially
where data variables from dual-finance economies is necessary. Aspects of this study
concentrate on one key area of macroeconomics: monetary policy management in a dual-
finance system. The major focus of this study concentrates on practices of the
conventional monetary policy and the Islamic monetary policy, the principles of shari’
and the principles of Islamic economic system.

The monetary policy transmissions for the conventional monetary and the Islamic
monetary system. The transmission channels under both systems among other relevant
aspects of the topic. The empirical analysis is based on annual data spanning 1991-2016.
The justification for the period is that it is during this period that all the selected countries
registered enormous growth and development in the Islamic finance and banking sector.

Although the study takes cognitive of the several monetary policy theories, this study also
tried to trace if Islamic banking and finance and the Islamic economic system is
underpinned by any of the contemporary monetary theories in its analysis of the
 22

alternative Islamic monetary policy analysis and implementation. The study was limited
to only eight selected Muslim majority countries with the highest global Islamic finance
asset shares as in indicated in the brackets. They include Saudi Arabia (31.70%), Malaysia
(16.70%), Kuwait (10.50%), Qatar (7.70%), Turkey (5.80%), Indonesia (3.80%), Bahrain
(1.70%), and Pakistan (1.20%). The period spans from 1991-2016, a period during which
the countries under studies registered massive finance growth under both the Islamic and
conventional systems.

1.9. Organization of the study

This study is organized into six main chapters which are summarized as follows.

1.9.1. Chapter One: Introduction

The first section covers the background to the steady in which the role of monetary policy
is stressed, followed by a brief history of the circumstances and reason for the prohibition
of interest rate in the early Islamic state and the eventual evolution of the Islamic
monetary policy. The statement of the problem is then stated, followed by aims and
objectives, general and specific research questions are stated, significance of the study,
contributions that the study will make, the scope and limitations foreseeable in the study
and lastly the organization of the study.

1.9.2. Chapter Two: An overview of the conventional financial and monetary system

The second section briefly covers the main aspects of conventional central banking
practices and the monetary policy system. These include such aspects as an introduction
to the conventional central banking and the monetary system, the history of the
conventional central banking and the monetary system. Also, the aims, targets and
objectives and strategies of conventional central banking and monetary policy, the
priorities of conventional central banking and monetary policy, the roles and functions of
the conventional central bank, the conventional monetary policy tools. Since it forms the
prime policy for conventional monetary management, the theory and history of interest
rate is discussed and a detailed mechanism of monetary policy.
 23

1.9.3. Chapter Three: An overview of the Islamic financial and monetary system

The third section briefly covers the main aspects of Islamic central banking practices and
the monetary policy system. These include such aspects as an introduction to the Islamic
central banking and the monetary system, the history of the Islamic central banking and
the monetary system. Also, the aims, targets and objectives and strategies of Islamic
central banking and monetary policy, the priorities of Islamic central banking and
monetary policy, the roles, and functions of the central bank from the Islamic perspective,
the Islamic monetary policy tools among other aspects.

1.9.4. Chapter Four: A review of the related literature

The fourth section looks at both theoretical and empirical studies that have taken place in
and around the area of this study.

1.9.5. Chapter Five: Theoretical foundations on the superiority of the Islamic

financial and monetary system over the conventional system

The fifth section begins with a brief introduction and then lays down the theoretical
epistemological foundations espousing the superiority of the Islamic monetary system.
The money demand frameworks for both the conventional macroeconomic thoughts and
their eventual monetary theories, sources of inflation and inflation-output trade-offs
according to the perspective the main macroeconomic theories are all covered. This is
followed by theoretical comparisons of the Islamic financial and monetary system’s
effectiveness as well as its superiority over the conventional one in facilitating the
achievement of macroeconomic goals.

1.9.6. Chapter Six: Methodology and empirical estimations of the study

The sixth section forms the last section of our study. Under this section, the cointegration
techniques; panel FMOLS, panel DOLS and the bounds ARDL econometric
methodology is used in analysing the data and making the necessary estimations, analysis
and discussion of results and the policy recommendations.
 24

CHAPTER TWO

AN OVERVIEW OF THE CONVENTIONAL MONETARY POLICY

FRAMEWORKS AND CENTRAL BANKING

2.1. Introduction

This section covers an overview of the main aspects of Conventional central banks’
operations and monetary policy systems. After a brief introduction to the conventional
central banking and the monetary system, the history of the conventional central banking
and the monetary system is presented. The strategies, aims, targets and objectives of
conventional central banking and monetary policy, the priorities of conventional central
banking and monetary policy, the roles and functions of the conventional central bank,
the conventional monetary policy tools. Since it forms the prime policy for conventional
monetary management, the theory and history of interest rate is discussed before a
detailed mechanism of monetary policy is presented. Finally, a conclusion is drawn.

2.2. The Conventional Central Banking and the Financial system

There are varying conceptual and theoretical frameworks of what exactly a central bank
is and debates of whether they are relevant continue to rage on. The difficulty in
conceptualizing and defining central banking could not be expressed any better than in
Goodhart et al., (1988) who out rightly acknowledged that defining central banking is
problematic. According to Ugolini (2017), central banking refers to the joint provision of
a set of public policies to counter the tendency of market failures in the financial sector
of an economy.

Central banking, therefore, is concerned with the operations of the monetary authorities
of the country or region. From the traditional viewpoint, any central bank is responsible
 25

for the issuance of the currency, management of the banking and financial system,
formulation of relevant monetary policies with a view to influence commercial bank
operations and the regulation of inflation and deflation tendencies of the economy.

Analysing the central bank of the Republic of Turkey’s reaction function, Erdem et al.,
(2017) make several citations about this concept. They categorized their citations in
relation to the 2007-2008 global economic meltdown. They note that many of the studies
were conducted before the crisis including (Bernanke and Gertler, 2000; Cecchetti, 2003).
The common factor among them, however, was that they had two dominant views; (i)
central banks should be interested in pursuit of all those financial variables that affect
inflation and output and (ii) central banks ought not to directly deal with financial stability
but should intervene immediately after the crisis has emerged (Eichengreen et al., 2011).

However, after the emergency of the global financial crisis, the responsibilities of central
banks towards financial stability were discussed at length within the scope of both macro
prudential policies and reaction functions. They list down Castro (2011), Milas and
Naraidoo (2012), and Lee and Son (2013) as good example of such studies in which the
central bank reaction functions were estimated with added new financial variables, after
the occurrence of the global financial crisis.

As pointed out earlier, central banking operations are synonymous with monetary
economies. This is because there was no talk of central banking until after the monetary
economies had evolved especially after the fiat money was invented. For example, the
success of the first modern central bank (Bank of England) is attributed to the fact that
the people of England, particularly the Londoners had been accustomed to the use of bank
notes (Quinn, 1997). Central banking and monetary policy therefore are two sides of the
same coin.

Since then, the philosophy behind the existence of central banking is monetary policy
management. As such, central banks are part and parcel of the body of the most important
players in the financial markets. Operations by these monetary authorities henceforth
directly affect the financial market variables including the interest rates, the credit
amounts, the exchange rates among other variables. The final impact of such operations
rests on the aggregate output levels and the level of inflation in the economy.
 26

Despite the above unequivocal usefulness, there still many debates on whether central
bank as an entity important or even necessary today are. Therefore, much as this is not
the focus for this study, a more detailed understanding of the historical origin and
importance of central banking and monetary policy management becomes necessary.

2.3. History and evolution of the conventional central banking and the monetary
system

The most desired approach to understand and appreciate the evolution of central banking
operations commences with the definitions and origin of the word bank itself and then the
central bank. Across the economic history, the jury over the origin of the term bank is yet
to be settled. On one hand some scholars have concluded that the term originated from
the Italian dialect route word “banco” which means the bench / counter over which the
medieval moneychangers used to deal with their money transactions. In this line of
argument, the central banking appears to have evolved to fix the payment system in the
financial sector.

On the other hand, other scholars argue that the term bank derives its origin from the
Germanic term “cliff” which means the amount of a joint stock that a public entity
handles. This line of reasoning equates the term to the Italian word “monte” which means
to monetize. This clearly underscores the argument that central banks were created
purposely to monetize government deficits especially following heavy warfare
expenditures deficits (Nicholson & Conant, 1909, p. 8-9).

The origin of the central banking operations dates to the 13th century (Ugolini et al., 2018).
There has been a great deal of scholarly works on the evolution of central banking
activities. Such works as: Ugolini (2017), Bordo and Siklos (2018), Giannini (2011),
Capie et al. (1994), Goodhart (1988), among other studies. Ugolini’s research work,
however, stands out given his chronological and systematic analysis. Accordingly, the
central banking theory cannot clearly be conceptualized without a close look at its roots
and circumstances surrounding its evolution.

Ugolini (2017), made mention of the most outstanding historical evidence on the episodes
of central banking evolution process since the 13th century as; the Venice (13th-18th
centuries); Barcelona (15th-19th century); Genoa (15th- 18th); Naples (16th – 18th);
 27

Amsterdam (17th -18th); Hamburg (17th-19th); Sweden (17th-19th); England (17th-20th);

Austria (18th-19th); France (18th-20th); The United States (18th -20th) and lastly the
European Union (20th-21th).

The Bank of England which was established in the 17th century (1694) is considered the
first formal central bank in modern history. It was established on a temporally basis to act
as the monetary authority for the monetary policy implementation by using specific
monetary policy instruments (Goodhart, 1988, p. 45–46). At the beginning, it served both
as commercial as well as the central bank. This however caused conflicts with other
commercial banks. The bank therefore quickly abandoned the profit maximization motive
and metamorphosed into a non-competitive, non-profit oriented institution solely
responsible for monetary policy management (Goodhart, 1988). The main premise upon
which the modern central bank operations are directed is to achieve both price stability
and financial stability (Alada, 2018; Erdem et al., 2017; Kara & Öǧünç, 2008).

Although it started voluntarily and on a temporary basis, its operations created a lot of
stability in both the banking and financial sectors of England. This stability in the
financial sector boosted sustained economic prosperity in England contributed greatly to
its later establishment of a permanent institution. Since then, this has been the model for
central banking activities which other central banks all over the world including the
Federal Reserve Bank (1913) and the European Central Bank (1998) duplicate to this day.

The central bank history in the Muslim majority countries like majority of the central
banks in the world is a 20th century phenomenon. Most importantly, the core function and
role of the central bank in nearly all countries including the Muslim majority countries
remains that of currency issuance and management and regulation of the banking and
financial institutions to ensure price and financial stability and ultimately economic
stability.

Monetary policy on the other hand deals with the process by which the monetary authority
controls the monetary base13 with the goal to achieve price stability in the economy.
Whereas it has been stated that monetary policy management is as old as the central
banking itself, the term was never used until the 20th century. Under the conventional

13
Monetary base consists of the total number of notes and coins in circulation plus the banks’ deposits held
in their current accounts at the central bank (Bain and Howells, 2003).
 28

system, the monetary authorities either target the money supply (monetary targeting
regime)14 or the inflation rate (Inflation targeting regime)15 and or the interest rate (Interest
targeting regime)16.

By default, therefore, monetary policy is associated with the origin of money, money
supply and the monetary system (Davies, 2002). Before explaining the origin and details
of monetary policy, an understanding of the meaning of money, the functions of money,
the characteristics of money and the different kinds of money becomes compellingly
desired. Money in simpler terms is defined as anything that is generally acceptable as a
medium of exchange (Miller and Roger, 1993). It is the most liquid of all assets. The
above definition implies that anything is money if it is accepted as such.

The other standard roles that money plays include its being used as a store of value, a unit
of accounting (standard of value), a standard for deferred payments, among others. For it
to execute its functions effectively, money possesses a cross range of characteristics
which include being portable, durable, standardisable, divisible, and lastly easily
recognizable from the counterfeit assets among other properties. Although there may be
exceptions, the above properties are largely accepted as the main characteristics of good
money. For example, gold and silver which possess all the above properties have through
ages been accepted as popular a form of money (Davies, 2002, p. 62-65; Toutounchian
& Iraj, 2009).

There are two basic types of money: the commodity-based money and the fiat-based
money (Acton, 2001). The commodity-based money functioned during the barter
economic system. The main feature for the successfulness of any trade transaction under
this system, though undesirable, was that it depended the existence of a double
coincidence of needs between the two trading parties (Devies, 2002). This type of money
therefore was characterized with several short comings such as the lack of a method of
storing generalized purchasing power, lack of a common unit of measure and value, lack

14
A monetary policy strategy in which the monetary authority aims at stabilising the value of money and
the eventually exchange rate by targeting quantity of money supplied (Rolnick and Weber, 1997; Dewald,
1998).
15
This is the most recent advancement in monetary literature. It is strategy in which the modern central
bank directly targets price stability / inflation (Epstein, 2007; Cecchetti, 2000; Mishkin (1999; Posen
(1995).
16
A monetary policy strategy whereby the central bank increases or decreases the short-term interest rate
to stabilise output and inflation (Chailloux et al.,2009).
 29

of a designated unit to use when writing contracts requiring future payments among other
difficulties. Therefore, as the economies expanded in terms of tradable goods and services
across a multiplicity of societies, better payment systems starting from the trading-post
economies gradually evolved through to the fiat money that eventually ushered in an all
together a new economic system, the monetary economy.

Under the monetary system, the different kinds of money sited in history such as corn,
sheep, skins, copper, salt extra all had one thing in common; all were physical
commodities (Samuelson, 1973). Such economies are therefore referred to as the
commodity money economies. As societies advanced however, mining of precious metals
such as gold and silver which possessed the key properties of good money in abundance
as elucidated above emerged (Acton, 2001). Such metals immediately took predominance
as the main types of commodity monies, particularly on the commencement of the
industrial revolution in 1800s (Colander, 2008).

Subsequently, minting of coins whose metallic content had a value in nonmonetary uses
equal to their exchange value of money took centre stage as the industrial revolution
galvanized across Europe. Different governments for example issued gold and silver
coins whose face value was equal to their market values. Over the years, coins, paper
currency and other forms of money represented a significant evolution of money (Davies,
2002). However, the big question remains on the origin of money and the determinants
of money supply.

2.4. The origin of money

In brief, the actual origin17 and invention of money is not clearly known. However, the
probable oldest form of money dates back around 9000 BC to 6000 BC in a barter
dominated environment. But as the needs to exchange goods expanded, more advanced
and efficient ways of exchanging goods and commodity were developed (Davies, 2002).
Specifically, Sir John Money is believed to have invented money in 3016 B.C. and eased
trade as people were freed from running around in search of barter trade commodities.

17
For more details, see Davies, “A History of Money: From Ancient times to the present day” (Cardif:
University of Wales Press, 1994) for a broader survey of the history of money.
 30

As for the banking function in the form we have today, it originated from Babylon,
Mesopotamia between 3000 - 2000 B.C. (Davies, 2002, p. 48). Indeed, like today, the
amount of money supplied in the economy was always determined by the monetary
authority. In other words, the ultimate authority over the total money supply in any
economy is vested in the authority of the central bank. As a sole determinant of the
amount of money in the economy, the central bank operations are by default directed
towards monetary policy management to avert the economic predicament that is
associated with any kind of failures in the payment system (Rochon and Rossi, 2007).

The history of monetary policy reveals that money evolved from physical entities of
scarce goods backed by precious metals, gold and or silver (Issing, 2010). Monetary
policy under the gold standard was determined by the evolution of gold reserves and was
constrained by the balance of payments. Among other goals for the conduct of monetary
policy at that time was to defend the external value of the currency which was based on
the gold parity to other currencies.

In the 20th century, particularly after the colossal failure of gold standard and the Breton
woods system, the monetary policy has undergone dramatic changes from gold to paper
currency (Issing, 2010). However, despite changes in the monetary policy instruments
over time, the ultimate objective of achieving price stability and financial stability
remains pretty much the same. The next sub section takes on an overview on the roles
and functions of the central bank in the pursuit of the above stated two objectives.

2.5. Roles and functions of the Conventional Central Banks

Central banking functions are defined controversially by different economists (Ugolini,

2017). This controversy has been reasoning why there has never been a list of agreed
upon functions of the central bank. For example, while Price (1998) lays down five key
activities of for the central bank that include interest rate setting, supervision of
commercial banks, government debt managing, running the payment system, and lastly
operating a branch network. Bruni (2001) offers a more complicated framework in which
he identifies eight areas as the main policy focus for central banking operations. Bruni’s
work is closely related to that of De Kock (1949), who also listed eight roles and functions
for the central bank and devoted separate chapters in which each is elucidated. Elaborative
as it may seem De Kock’s work has not been short of criticism either.
 31

Therefore, the most recent studies have thus come up with a more comprehensive list as
roles and functions of the central bank (Singleton et al. 2006:5). Nevertheless, the
common fact about all central banking studies is their acknowledgement of central banks
as being responsible for two key basic functions, maintaining price stability and financial
stability. However, across the monetary economics scholarly literature, there are up to ten
roles and functions (Singleton 2011, p. 5-11).

The most traditional role of central banks is the issuance of legal tender banknotes and
coins. Generally, central banks enjoy the monopoly of not only being the sole issuer of
notes but also involved in their printing, processing as well as distributing to the banking
industry. The printing of banknotes is very cheap and therefore, a valuable privilege over
which the central banks enjoy enormous monopolistic rights (Bank of Canada 2001). In
the developing countries, the central banks exploit this opportunity to earn seigniorage18.
In other words, the central bank uses non-interest- bearing notes to purchase securities
for which it pays no interest to generate income. Central banks are thus key sources of
government revenue in particularly developing countries.

Central banks are responsible for the formulation and implementation of monetary policy.
Though seemingly straight forward, this function has generated a lot of interest across the
economists’ spectrum as much as it has among the observers (Singleton, 2011).
Specifically, the controversy is whether the monetary policy decisions should be the role
of central banks, or whether it should be a joint policy by government and the central
bank, or it should be an absolute responsibility for solely the government. This debate is
yet to be resolved.

However, as a matter of fact, central banks influence monetary and credit conditions
owing to their strategic position in the financial sector. By manipulating monetary policy
instruments such as open market operations, discount windows, reserve requirements,
credit ceiling, moral suasion among others, the central bank can influence aggregate
spending levels, key economic variable like inflation rate, short-run output and
unemployment/employment levels of an economy (Bindseil, 2004). In short, any

18
Seignorage refers to the revenue that the government or the central bank earns through printing money
(Bresciani-Turroni, 1937; Cagan, 1956).
 32

technique or set of techniques that the central bank chooses to use is aimed at influencing
the bank lending and the aggregate spending in the economy.

Central banks also function as government bankers. Across the world, central banks carry
out banking and agency services for and on behalf of their respective governments,
especially public debt management (Faure, 2013). They are normally the major supplier
of banking services to governments, payment settlements between governments and
commercial banks usually take place through accounts at the central bank. Government
borrowing both domestic and foreign are usually conducted by the central banks. As noted
earlier central banks extend loans to governments as well as government agencies.

Central banks act as the custodians for the required reserves of the commercial banks, any
other cash reserves of commercial banks and uses the excess reserves in settlement of
clearance balances among them. This function shades light on why commercial banks are
required to maintain reserve accounts as well as current accounts with the central banks.
The former account is the convenient and most highly secure location keeping their
required reserves and the latter is where the settlement of interbank payments and
payments between commercial banks and the governments. Besides, the central banks
have the authority to change the reserve required ratio to influence the level of liquidity
of the depository institutions (Faure, 2013; 58).

Central banks play a central role in preserving the integrity of the financial system. The
very essence of central banking operations is aimed at achieving sustainable economic
growth and full employment through maintaining financial as well as price stability.
Economic historians have exhaustively laid down the extent to which banking crises such
as wiping out deposits, crippling the private sectors’ ability to obtain new credit, failing
the interbank payment and settlement system among financial and economic disruptions.

To salvage the financial status of the economy, central banks act as prudential supervisors
to banks and in exceptional circumstances as an emergency lender of last resort to avoid
a systemic failure in the banking industry. In some cases, the central banks are granted
powers of supervising over the entire financial sector, including financial companies and
insurers. As to whether that is appropriate or not, the views of economists continue to
vary (Goodhart and Shoemaker, 1995). In the recent literature, the central banks’
oversight function over the banking system is categorically referred to as a macro
 33

prudential policy while their supervision of the individual banks is known as micro
prudential policy (Singleton, 2011).

Central banks carry out governments’ policies regarding the exchange rate and act as the
custodian of the foreign asset reserves of the country. They essentially hold stocks of
diversified international reserves on behalf of the government and public. They hold such
foreign assets to intervene in the exchange market to prevent unnecessary volatility in the
exchange rate as a way of mitigating economic crisis (Calvo and Reinhart, 2002). Many
scholars argue that the effectiveness of the central bank policies is measured on its ability
to maintain stability in the foreign exchange market of the country (Fatum and Hutchison,
2003; Kearns and Rigobon, 2002; Ramaswamy and Samiei, 2000; Fatum, 2000).

Across the monetary economics literature, the effectiveness of central banks as the main
foreign exchange interventionist agent that influences the exchange rate and its volatility
especially for the developed countries is well documented (Eijffinger and Gruijters, 1991;
Dominguez, 1992, 1993, 1998; Connolly and Taylor, 1994; Cheung and Chinn, 1999,
etc.). Other reasons for holding foreign reserves are for transaction purposes such as
paying off governments’ maturing loans. Also, foreign inward investments largely take
place in internationally stable currencies such as the United States Dollar, the Great
Britain Pound, and the Euro extra. Sometimes, central banks purposely employ
administrative controls over external transactions through adjusting in the interest rates.

Central banks facilitate and or promote economic growth and development by directly
lending to both the government and the public for investment (Capie, et. al., 1999, p. 69;
Cameron and Neal, 2003). As pointed out earlier, the ultimate target of proper monetary
policy management is to achieve sustainable price stability. Once achieved, it facilitates
faster rates of economic growth and development towards the steady equilibrium state.
This is especially significant in developing countries.

In another but rather very contentious debate, the central bank can boost economic growth
and development by undertaking monetary activist policies that arouse the demand side
of the economy. However, such policies are interpreted differently by the different
macroeconomic schools of thought (Motyovszki, 2013) (Motyovszki, 2013). The
different schools are broadly divided two major views; either in support or against the
notion that money is neutral. Monetary authorities can cause changes to the real variables
 34

of the economy by fine tuning monetary policies (Orthodox Keynesian view) or such
alterations in the demand management policies are completely ineffective since money is
neutral (Orthodox Classical View).

Owing to its significance and the controversy surrounding it, we briefly consider a brief
look at the issue based on a unified framework of the aggregate supply-Aggregate demand
using the Phillips curve as it has been the epicentre for this discussion since its evolution
in the 1950s. The oldest view of the money-output debate emanates from the classical
political economic thought. According to the classical economists, an economy can be
separated into two non-interacting sectors, the real and the nominal one (Nomine, 2010).
This is what later came to be known as the classical dichotomy. Under the assumption
that prices always adjust in a perfectly flexible way to clear all markets, real output can
only be determined by changes in the real fundamentals of the supply side, not demand
side. So, changes in the monetary policy do not have any effect on the real demand side
of the economy. That is, monetary policy cannot cause economic growth.

In other words, money is neutral since nominal variables and shocks cannot cause changes
in the real variables such as employment and output. In the context of the AS-AD
framework, the long-run aggregate supply curve is vertical at the potential output level
and therefore monetary policy changes only induce changes in the general price level as
the negatively sloping AD curve shifts along the long-run AS curve (Humphrey, 1985).

Following the effects of the great depression of 1926-1932 that shook up the foundations
of the classical views presented earlier, a new different school of economic thought
emerged, the orthodox Keynesian view. As opposed to the classical view, Keynes (1936)
assumed that prices are sticky and perfectly fixed in the short run (markets are not
efficient in that they adjust slowly to shocks). Accordingly, real economic activity can be
caused by changes from the demand side, not the supply side. Therefore, under this view,
the classical dichotomy and neutrality of money assumptions do not hold. In the context
of the AS-AD framework, the AS supply curve is Horizontal and so aggregate demand
management policy fine-tuning leads to changes in real variables such as output and
employment. However, on the assumption that there is a very high interest elasticity of
money demand, the Keynesian theory downplays the full ability of monetary policy
changes to affect demand. So, Keynes instead favoured and recommended fiscal policy
as more effective in causing the desired changes to the real variables (Nomine, 2010).
 35

For the neoclassical synthesis theorists who adopted some assumptions from the orthodox
Keynesians but maintained the classical assumption on perfect price flexibility in the long
run, the central can accelerate economic growth through monetary policy fine-tuning.
However, in the long run, the economy reverts to its long-run steady state (Mankiw,
1990).

The Monetarist view propounded by Friedman (1956) rejects the idea of accelerating
economic growth through demand management policies. To this view, economic growth
stems from structure feature changes in the labour market (Mankiw, 1990). Due to the
adaptive nature of economic agents, any short-term trade-offs between inflation and
unemployment can only bear temporary effects on the real variables but produce
permanent effects on the inflation level of the economy. Therefore, policy makers should
instead stick to rule-based monetary policy measures as opposed to discretionary policy
undertakings. Monetarists argue that although such policies can achieve temporary
unemployment, the damage it causes to the economy in terms of higher inflation due to
the existence of the nonaccelerating inflation rate of unemployment that cannot be
influenced by the demand management policy fine tuning (Romer, 1990).

The new classical theory rejects the assumption that expectations are adaptive. Instead,
they assert economic agents are rational in nature and therefore can use all the available
information to make informed decisions and their expectations are correct on average.
So, it plausible to argue that the rational expectations hypothesis (REH) was developed
as a critique to the monetarists’ theory that in contrast to the new classical view, assumes
back-ward expectations in that they are formed in an adaptive manner (Humphrey, 1985).
The back-ward adaptive expectation assumptions imply that under accelerating inflation,
economic agents would systematically underestimate actual inflation even if it were
announced by the monetary authority, which is irrational.

However, in terms of the Phillips curve, both Monetarists and New classicals have some
point of agreement, their views seem to point to a return to the orthodox classical view in
which money is neutral in the long run. Both theories contend that there exists a short-
run inflation – unemployment trade off but only if the central bank surprises economic
agents with its policy actions. Otherwise, demand management policy fine- tuning are
 36

unable to move an economy towards and or away from its natural rate (NAIRU)19
permanently in the long run because money is neutral. That is, output is independent of
shifts in money supply and prices in the long run (Miles & Scott, 2000). Therefore, like
the new classical theorists, the Phillips curve in this case also takes a vertical shape at its
long-run steady state of employment.

Therefore, often, central banks are given broad mandate by such governments to intervene
and foster accelerated economic development (Epstein and Schor, 1992). For example,
the where commercial banking industry is weak, central banks open and operate own
branches so that they do not only boost the industry but also give confidence to potential
new entrants into the sector. Over and above, central banks provide the crucially needed
finances to development projects as well as corporations. They equally endeavour to give
support to essential corporations and sectors; particularly when borrowing externally for
the promotion of development plans and activities.

Central banks act as advisors to their respective governments on economic policy. The
systematic and continuous collection of data on important micro and macro-economic
variables enable central banks across the globe to attain expertise on a range of economic
as well as financial matters. Unsurprisingly, therefore, beginning with the last half of the
20th century to date, central banks have been at the centre stage in economic modelling
studies. Accordingly, it is considered prudent management for treasury to seek the
counsel of officials from the central bank before any important economic policy decision
is reached (Weller 1989; 22). In fact, all central banks have got research and economic
departments through which they provide detailed periodical economic and statistical data
to both governments and the public. Such data guides governments in their economic
policy formulations (Faure, 2013).

Central banks participate in cooperative international monetary arrangements. The ever-

increasing openness of economies because of globalization compels economies to
cooperate in the management of the international monetary system and regulation of the
international banking system. This cooperation takes different forms such as exchanging
information, joint formulation, and discussion new policy initiatives, among others.
Singleton (2011) points out that those cooperation initiatives amongst central banks began

19
NAIRU stands for the non-accelerating inflation rate of unemployment. It represents the long run level
of unemployment which cannot be altered by changes by the monetary authorities through policy changes.
 37

as early as 1930 when central banks were still in their infant stages in assuming the
enormous roles that they have today. He stresses that the main hub for central bank
cooperation has been the bank for international settlement in Basel.

There are other functions which central banks are sometimes asked to take on as agents
with special close relationship with governments. Additional tasks such as provision of
banking services to the public, consumer protection roles, taking up part and parcel in the
ownership of stock exchange markets or simply the operation of stock exchange registry
(Mckinley and Banaian, 2005). These are categorized as other functions. Central banks
execute the above roles and functions by use of monetary policy tools which are explained
as follows.

2.6. Tools of central banking and monetary policy

Monetary policy tools are the instruments that the central bank employs to achieve its
pre-set goals. Generally, conventional central banks employ three primary policy
instruments in pursuit of its goals. These tools include open market operations (OMOs),
legal reserve requirements (LRR), and discount window lending (DW). There are
however other miscellaneous tools known as macro prudential instruments that central
banks sometimes use to ensure depository institutions adhere to the rules and hence
facilitate the realization of the different monetary policy goals. Such tools as moral
suasion, selective credit controls like margin requirements which specifically target the
markets over which overall monetary policy has no effect, interest rate corridor, among
others fall under macro-prudential policy tools. These instruments are explained as
follows.

2.6.1. Open market operations (OMO)

This means the buying and selling of government securities such as the treasury bills and
the government bonds with a view to influence the quantity of money and total credit in
the economy. Under the conventional monetary system, OMO is considered the most
important instrument for monetary policy implementation and thus forms the primary and
basic determinant of interest rate and monetary base (Millers and Roger 1993). These
operations impact the economy through their direct effects on the changes in the
depositary institutions’ reserves, changes in the interest rates and lastly changes in
 38

expectations for both analysts and ultimately the wider public. Open market operations
are mainly categorized into two kinds: outright open market operations (Repos) and
temporary open market operations (Reverse Repos).

2.6.1.1. Outright open market operations (Repos)

Under this category, the central bank drains or adds to the reserve balances of the
depository institutions by permanently selling or buying securities respectively in the
secondary market. In other words, the operation under this type of OMO is conducted by
the central bank with no strings attached. They are otherwise called dynamic open market
operations, undertaken to permanently change the reserve levels of depository
institutions.

2.6.1.2. Temporary open market operations (Repos and Reverse Repos)

As the name suggests open market operations of this type are on a temporary basis. Under
this type of OMO, the central bank buys or sells securities in the secondary markets with
an agreed upon condition that the seller must buy them back at a pre-specified period in
future. These are also divided into two forms; the Repurchase Agreements (Repos) and
the Reverse Repurchase agreements (Reverse Repos). They are short-term contracts
whose durations do not exceed 15 days (Miller and Roger, 1993). Central banks conduct
this type of operation to make a temporary alteration in the depository institutions’
reserves. They are known as defensive open market operations, undertaken to adjust or
maintain the current level total depository institution reserves.

As a tool of monetary policy, open market operation is the most effective instrument over
which the central banks do not only enjoy complete control but also easily reversible and
flexible. This explains why it is widely used across all central banks in the world.

2.6.2. Discount window lending (DR)

This refers to the monetary policy practice in which the central bank lends money to the
depository institutions at a specified discount rate. This is undertaken to alter the quantity
of money as deemed desired by the public. After the open market operation tool, discount
lending or lending facility as its popularly known is the second most important instrument
of monetary policy. The central bank manipulates the discount rate to either induce
 39

depository institutions towards borrowing more reserves or induce them to borrow fewer
reserves. For example, a reduction in the discount rate induces them to borrow more
reserves while an increase discourages them.

This facility is undertaken for two major purposes; to reduce volatility in the bank rate
and as a conduit to rescue insolvent depository institutions with liquidity challenges. So,
the central banks perform their lender of last resort role to commercial banks through the
discount window policy. The monetary authorities are thus able to shield the banking
system from panic, crisis, and financial market collapses through extending discounted
credit to sound banks in the economy.

2.6.3. Legal reserve requirement (LRR)

This simply refers to the fixed number of deposits which commercial institutions must
legally keep with the central bank as a ratio of their total depository reserves. Under this
arrangement, conventional commercial banks can create money (new deposits) out of the
deposits that customers keep with them. The monetary authority determines the current
level of reserve requirement based on the past level of deposits from the commercial
banks (Alper et al., 2013; Moore, 1988; Goodhart, 1984, p. 212).

From the deposits the government through the central bank creates seigniorage20 profits
which consequently causes a decrease in the aggregate purchasing power of the money
(Ascarya, 2007). The history of these fractional reserve ratios dates to the 1860s but never
assumed importance as a powerful tool of monetary policy until the 1930s. Specifically,
in 1933, the United States of America was the first country to grant monetary authorities
the legal powers to use Reserve requirement and was followed by New Zealand in 1936
(Goodfriend and Hargreaves 1983; Sayers 1957, p. 85–91).

The justifications for the reserve requirements vary from institution to institution and in
some cases from country to country, as it does, amongst monetary economists themselves.
For example, according to the European Central Bank (ECB), the legal reserve
requirement serves in a two-fold framework by way of stabilizing the money market
interest rate as short term transitory monetary shocks are buffered through reserve

20
Seignorage refers to the revenue that the government earns through printing money (Bresciani-turroni,
1937; Cagan, 1956).
 40

holdings. The second fold is that minimum reserve requirements create the essential
structural liquidity shortages in the banking system of the euro region (ECB, 2005b, p.55).
However, much as most of the industrialized economies especially in the Euro system
have tended to focus on the above two, there are up to five justifications for the required
reserves (Bindseil, 2004).

Lately, however, reserve requirement as a tool has come under constant criticism due to
its immediate liquidity related problems that it rolls out as a tool of monetary policy thus
increasingly being relaxed by many central banks. In the early 1980s, some economists
noted the inherent instability of fractional-reserve banking (Diamond and Dybvig 1983).

Nevertheless, this tool works in such a way that whereas changes in the reserve
requirements do not affect the total amount of reserves in the economy, they directly
affect the amount of money supply and credit because of their impact on the multiplier.
For example, a decrease in the required reserve ratio increases the size of the multiplier
and a decrease in the reserve requirements leads to an increase in the quantity of money.

Similarly, an adjustment in the reserve requirement changes the value of total bank credit
due to its impact on the credit multiplier. In short, the monetary authorities adjust reserve
requirements to influence the quantity of money and credit to achieve a specific monetary
policy target (Miller and Roger 1993). Among the miscellaneous means through which
conventional central banks conduct monetary policy are the following:

2.6.4. Moral suasion

Under this tool, the central banks influence the operations of financial institutions to
behave in a manner that puts public interest at the fore front. This is done through
inducements and persuasions. Sometimes, even threats regarding considerations to be
made on future lending facilities.

2.6.5. Selective credit controls

The central bank sometimes targets specific markets that remain unaffected by the overall
monetary policy operations by use of margin requirements and credit controls. These in
most cases invoked during specific period of economic difficulties such as wars with a
view to curb inflationary tendencies in the market.
 41

2.7. Objectives, Targets, Goals and Priorities of Conventional Central Banking and
Monetary Policy

In this subsection, we briefly look at the process through which the monetary authorities
identifies their strategi and priorities which facilitate their realisation of the desired goals.

2.7.1. Goals

Under the macroeconomic framework, there are two major kinds of policies: the monetary
policy and fiscal policy. Fiscal policy is related to the conduct of government revenues
and expenditures while monetary policy is concerned with the process by which
governments through their respective monetary authorities control the growth and
stability of the monetary base. The mentioning of the fiscal policies under monetary
economic studies should not be surprising because without fiscal discipline, the objectives
of monetary policy may be futile (Hossain, 2009). The central bank influences the cost of
money and credit using techniques aiming at the realization of specific objectives. So, the
monetary authorities influence economic activities through basically two major variables;
the money or credit supply and the interest rate as will be explained later.

In the conventional monetary policy literature, there are mainly six goals that the central
banks have been pursuing traditionally. These include price stability, high level of
employment opportunities, financial market stability, interest rate stability, foreign
exchange stability, and finally sustainable economic growth (Mishkin, 2004, 1996). The
desired level of employment opportunities is the one where the amount of labour
demanded is equal to the level of labour supplied. This is otherwise known as the full
employment level of unemployment, the natural unemployment rate21.

Price stability appears to be the most important goal which the central bank pursues very
effectively through monetary policy. The significance of stability in prices is underpinned
by the fact that inflation creates high levels of uncertainty and undesired speculations and
other sorts of market inefficiencies. Therefore, modern central banks have generally
zeroed down to one prime objective; price and financial stability (Erdem et al., 2017;
Tapşin, 2019). Such market inefficiencies distort economic activities and therefore
undermine the efforts to realise the macroeconomic goal of achieving sustainable

21
NAIRU stands for non-accelerating inflation rate of unemployment.
 42

economic growth. In addition, since the mid-1970s various studies consistently confirmed
the existence of a relationship between changes in the quantity of money and the price
level. Such works by Lucas (1980), Dwyer and Halfer (1988), Friedman (1992) Barro
(1993), McCandless and Weber (1995), Rolnick and Weber (1997), Dewald (1998),
Dwyer (1988) Dwyer and Hafer (1999), among other are good examples.

Stability in the financial markets is desired and pursued as an important goal by the central
bank because financial crises have exhibited an overwhelming ability to cripple the
financial institutions in economic history. Since crippled institutions cannot act as
effective conduits through which money is channelled to the public for investment and
other economic activities, ensuring financial stability in financial markets can be equated
to an insurance measure for economic growth realization (Mishkin, 2004). Like price
instabilities, the fluctuations in the interest rate creates a lot of uncertainty, discourages
consumers from making expenditure decisions on durable commodities and so generally
makes planning very difficult. The central bank therefore desires to ensure interest rate
stability to reduce the uncertainty and avoid the hostilities from the public that such
fluctuation normally create.

The ever-increasing level of openness of economies implies that the foreign exchange
markets stability takes on greater importance because it becomes central especially in
international monetary policy discipline. The appreciation and or depreciation in the
national currency against the international currencies creates unnecessary uncertainties
whose impact affects all the sectors of the economy. The monetary authority thus
undertakes suitable measures to ensure stability in the foreign exchange market. This is
achieved by controlling the money supply (Cecchetti, 2000).

Finally, the central bank aims at achieving sustainable economic growth by regulating
commercial banks’ liquidity needs. This enables commercial readily provide credit to
their clientele on a sustainable basis. Both industry and agriculture require both short- and
long-term credits for working capital and fixed capital needs, respectively.

2.7.2. Priority

Much as nearly all the six major goals appear theoretically consistent with each other, in
practice, it is not always the case. For example, in the short run, there is always a trade-
 43

off between price stability against unemployment, interest rate stability against price
stability and high employment particularly in the long run among other conflicts. It
therefore follows that the central bank cannot pursue all the goals concurrently. Whereas
many economists argue that the goals that central banks pursue are three: stable general
price level, high rate of employment, and sustainable economic growth rate, common
consensus has been built around price stability as the overlapping priority and goal for all
macroeconomic monetary policies and hence no conflict. Therefore, as already stressed,
in general terms modern monetary authorities pursue price and financial stability as their
main objective and goal (Hossain, 2016; Mishkin, 2004; Allen, 2004; Akerlof et al.,
1996).

2.7.3. Monetary policy targets and strategies

While the goals of monetary policy refer to the long run objectives such as price stability,
full employment, and faster rate of economic growth realization among others as
explained above, the targets of monetary policy refer to the intermediate objectives that
the central bank aims at directly to achieve its long run goals. These intermediate targets
lie between the monetary policy tools and the goals. They include such variables as the
monetary aggregates (M1, M2, and M3), the supply of bank credit and the interest rate
(Mishkin, 2004, 1996).

Since it cannot directly influence its goals, upon deciding the ultimate targets, the central
bank pursues different strategies to achieve the desired goal. The set of variables chosen
determines the specific strategy; monetary strategy in case monetary aggregates are
chosen, interest rate strategy in case of interest rate and the extra all of which have direct
influence on the ultimate goals of monetary policy especially price stability.

However, the central bank monetary policy tools have no direct influence on the
intermediate targets too. Therefore, the central bank chooses operating targets that are
otherwise known as instrument targets that lie between the monetary policy tools and the
intermediate targets. This include such variables as reserve aggregates (including
reserves, non-borrowed reserves, monetary base), interest rate (bank rate) and the like
that are more responsive to the monetary policy instruments (Neumann, 2000). Such
strategies are employed by the central bank because it is difficult to directly pursue long
term goals whose impact can only be realized after a long period of time, usually a year.
 44

In other words, the central bank can judge the effectiveness of a strategy towards the goal
when it hits the operating and the intermediate targets (Mishkin, 2004). Some variables
like interest rate are both operating as well as intermediate targets particularly where the
monetary authority pursues interest rate targeting strategy. The figure below summarizes
the operations of the central bank in pursuit of its monetary policy goals:

Table 2.1. Operations of the central bank in pursuit of its monetary policy goals
Monetary policy Operating Intermediate Monetary
Tools Targets Targets policy
Goals
Reserve
requirement

Discount Monetary
window Base
Money
Open market supply srice stability
operations & Financial
Bank
Assets and stability.
Minimum Sustainable
liquidity Liabilities Bank
Credit high output.
requirement
Foreign
Interest exchange
Selective Rate
credit stability.
control

Moral
suasion

Source: Azali (2005, p. 57)

2.8. The theory of interest rate under the conventional system

Interest rates play a fundamental role in the implementation of monetary policy under the
conventional system. It should however be noted that interest is not identical to interest
rate (Fischer, 1974). Whereas interest rate is calculated by multiplying its capital value,
the rate of interest is defined as the premium paid on money known as the price of money.
Since interest rate manipulation forms the prime monetary policy tool under the
conventional system and yet prohibited under the Islamic monetary system, a brief
understanding of how it operates is necessary to comprehend the logic behind its
prohibition under the Islamic system.
 45

The original Fisher model of interest rates theory basically relates to the nominal interest
rate. On the other hand, real interest rate is the rate after the adjustment of inflation. The
Fisher theory of interest rates is described as below:
1 i 1 r 1 π (2.1)

Alternatively, the above equation can be re-written as below:

I π 1 r (2.2)

Where; = the nominal interest rate, = the real interest rate and = the inflation
rate. From the equation as stated above, if increases by 1%, the nominal interest rate
will increase by more than%. If the value of (r) and are known, the value of (ὶ) can
be determined. On the other hand, if the value of ὶ and are known then the value of )
can be determined.

According to Watkins (2013), when the value of is small, then the value of is
approximately equal to (ὶ- . In the event of high rate of inflation, then more accurate
relationship must be considered. This can be expressed in any either of the following two
equations.

1 (2.3)

–
(2.4)

Regarding monetary policy implementation, the basic model of interest rate targeting is
based on the Fischer model, where is the nominal interest rates, is the real interest
rate and is the inflation target.

(2.5)

The above equation implies that when the real interest rate is the target, then ) is that
real interest rates, ) is the inflation rate and *) is the targeted inflation rate which is
expressed as follows:

∗ (2.6)
 46

The real interest rate is calculated by way of subtracting the inflation rate from the
nominal inflation rate . In other words, as earlier mentioned, real interest rate is the
interest rate after the adjustment of inflation. This is expressed as below:

). (2.7)

In the 1990s, a new rule of monetary management was developed. Specifically, Taylor
(1993) came out with the new formula known as ‘Taylor Rule’ whereby if the inflation
increased by 1 per cent, the central bank must increase the nominal interest rates by more
than 1% to stabilize the output (Asso et al., 2010). This, therefore, implies that nominal
interest rates must respond to the movement in inflation rates from targeted interest rates
and of actual and targeted output. The equation can be written as follows:

∗
∗ ∗
∗ (2.8)

Where; is the required short-term interest rate, is the inflation rate in the previous
∗
period, is the deviation inflation in the previous period from the target
∗
∗
inflation, ∗ represents deviation of output from its natural rate and is

the target real rate of interest. are constants that Taylor set at 0.5. The above
equation is known as interest rate rule or often referred to as the ‘Taylor Rule’ (1993),
which has since become the main feature of macro-economic models (Sims, 2013;
McCallum, 2000; Clarida, Gali and Gertler, 1998; Taylor, 1999).

Over the years, there has been an increasing appreciation of the fact that an interest-based
financial and monetary system is prone to banking crises, economic crises, political
turmoil all of which impede economic growth and development (Meera, 2004).

The high ‘passive interest income earnings’22 imply that instead of investing money in the
real sector where they can produce goods and services as they provide employment
opportunities to the public, the rich simply invest in bank deposits or public bill of debt

22
Passive income earnings are against the basic tenets of Islamic teachings since it kills the spirit of having
mercy and helping others in a selfless manner. The following verse stresses the significance of being
beneficial to others:
“Believers! … help one another in acts of righteousness and piety, and do not help one another in sin and
transgression. Fear Allah. Surely Allah is severe in retribution (surat al-Maida: 2).
 47

(Erdem, 2017)23. From this perspective, interest by default concentrates wealth in the
hands of a few individuals thereby widening the gap between the rich and the poor
contrary to the tenets of Islam as regards the social responsibility of the rich and wealthy
to the poor and needy (Dhar, 2013; Ahmad, 1994; Mannan, 1986). The Islamic
disapproval of concentrating wealth in a few hands as mentioned by the Holy Quran (59:
7) and emphasis on justice (14: 90) is beyond any doubt. The general impact of existence
of interest rate in an economy is depicted in the following drawing:

Figure 2.1. The general impact of interested-based monetary policy

Interest based Money High Econ growth

Real sector and Dev.
monetary creation and Inflation
contraction impediments
Policy concentration tendencies

Source: Sakti: 2007.

From the above figure, due to the existence of interest rates (as a price of capital) that
enables the rich to earn out of their “idle savings” with no or less risk, fractional reserve
requirement which enables the already wealthy bank owners to create more money (new
deposits) with no or less risk, the fiat money system among other features of the
conventional system, all concentrate money in the monetary rather than the real sector.
So, by default, the money which would otherwise be supplied to the real sector to facilitate
investment and active production of goods and services is instead channelled to the
monetary sector. Such practices impede economic growth and development as the real
sector contracts and eventually collapses (Ascarya, 2007). Most importantly, it is very
challenging for the economy to rebound back after a crisis under the conventional
financial and economic arrangement. This can be illustrated as follows:

23
The encouragement of selfish earnings through “passive” incomes (interest income earnings) as opposed
to the productive activities that benefit both the wealth owner and the public is among the many reasons
why interest has been made haram (prohibited) in Islam Yazır (1971, pp. 964-68).
 48

Figure 2.2. Credit demand and supply constraints during macroeconomic shocks in the
conventional system
Lower asset quality leads Economic slowdown and
to losses and bank capital falls in asset prices lead
constraints to lower collateral values.

BANK BORROWER
MACROECONOMIC
BALANCE SHEET BALANCE SHEET
CONSTRAINTS SLOW DOWN
CONSTRAINTS

Too risky Unwilling

Unable Borrowers’
to lend to borrow
to lend deleverage

LESS SUPPLY LESS DEMAND

Adverse macro
econ feedback
Tightened lending Too costly
conditions. to borrow

Source: Adopted from the global finance stability report (GFSR), 2013.

From the above figure, as earlier stated, during periods of macroeconomic shocks, the
adverse effects of the interest-based system that compact resources in a few hands of
society are clearly demonstrated. The banks’ balance sheets are constrained rendering
them unable to lend. The less supply of credit is worsened by the less demand from the
borrowers as their balance sheets are equally constrained and therefore unable to borrow
at a high interest rate. As a result, financial and economic crises become inevitable
following multiple stagnations in the business sector.

The general concentration of the national wealth or the world’s wealth in a few hands and
the consequential contraction of the real sector has broader financial and monetary
implications for the entire economy. For example, at the start of the World Economic
Forum (WEF) in Davos, one of the world’s leading development charity organisations,
Oxfam international, observed that 2018 had been a year in which the rich had grown
richer and the poor poorer. The same report specifically stated that by 2018, the world's
26 richest people were owning as much as the poorest 3.8 billion of the world population,
50% (WEF, 2019).
 49

Earlier on, the 2018 World Inequality Report (WIR), a similar observation had been
made. The report observed that from 1980 to 2016, the poorest 50% of world population
only captured 12 cents in every dollar of the global income growth. In contrast, the top
1% of humanity captured 27 cents of every dollar (WIR, 2018). Both reports and indeed
many more indicate an ever-widening gap the rich and the poor, which hinders much of
the efforts of fighting poverty. Yet Islam seeks to litigate this gap through social
institutions such as zakat and sadaqat as stated in the following verse of the Holy Quran:

Allah says:
“And those in whose wealth are a recognized right. For the needy who asks and
him who is prevented (for some reason from asking.” (Al-Ma`arij 70:24-25).

The financial and monetary implication of concentrating resources in a smaller section of

the population is that when faced with macroeconomic shocks, the economy is more
constrained in its ability to rebound as compared to the Islamic finance system in which
gains and losses are spread amongst the capital contributors and the business managers
through profit and loss sharing instruments such as mudarabah and musharakah contracts
(McKenzie, 2008; Zarqa, 1983)24. Most importantly, the spirit of humanity as well as
socio-economic justice is suffocated as the rich take advantage of the vulnerability
condition of the poor (Erdem, et al., 2009, p. 175-177, 227, and 255). Such actions and
behaviours contrast the basic teachings of Islam where the lender is cautioned against
dealing in riba and making conditions harder for the vulnerable borrowers (Erdem, 2017).

A more compelling example in the above regard is Turkey, during periods of her highest
political and economic instabilities of the 1990s. With a broken fiscal discipline, the high
rates of interest rates impeded the private sector from undertaking large-scale investment
decisions (crowd out effect)25. So, interest rates continued to skyrocket, enabling the rich
to reap bigger and become richer from the high interest incomes with minimum risk, as
the rest of the population suffered with heavy debt-servicing amidst high levels of
unemployment (Erdem, 2017, p. 101-102).

24
Also see Hasan, Maher & Jemma, Dridi. 2010. The Effects of the Global Crisis on Islamic and
Conventional Banks: A Comparative Study. IMF Working Paper, WP/10/201: 9.
25
Crowd out effect is an economic phenomenon in which an increase in government expenditures results
into squeezing private investment expenditure (Majumder, 2007).
 50

2.9. Conventional mechanisms of monetary policy transmission

The monetary policy actions of the central banks are transmitted to the economy through
their impact on the equilibrium position of the demand for money and the liquidity
preference (LM). Since the economy’s aggregate demand stems from the equilibrium
positions of both the LM and IS curves, it implies that the monetary policy actions
influence the aggregate demand of the economy. Therefore, under the conventional
central banking, a monetary policy that is intended to achieve price stability must function
through its impact on the aggregate demand of the economy (Mayer, 1978; Tobin, 1958,
1969).

In terms of impact, the monetary policy immediate effects are transmitted to the financial
system in two basic ways: (i) quantities involving the monetary authority balance sheet
and (ii) prices. The commercial banks’ reserves held by the central banks are affected and
consequently the interbank money markets. Similarly, the different financial market
segments that represent the second stage of monetary transmission such as money and
foreign exchange markets, interbank and government security markets, among others are
affected. Where the financial markets exist and operate efficiently such as the case for the
developed economies, the money and government security markets transmission enable
price formation over different maturity periods and the process continues.

The effect can either be gradual or immediate depending on the specific policy tool that
the central bank chooses to employ. There is no agreement on the actual number of
channels in conventional monetary system. Some scholars focus on three main channels
while others argue the channels are four. But according to Loayza and Schmidt-Hebbel
study (2002, p. 4-6), there are five channels through which monetary policy is transmitted
under the conventional system to the general economy. For Pohan (2008), the channels
are six and they include direct monetary channel, interest rate channel, asset price
channel, credit channel, exchange rate channel and the expectations channel. These are
briefly explained as follows:

2.9.1. Direct monetary channel

This is otherwise known as the direct money channel. It is based on the classical theory
which stresses the connection between the stock of money and the changes in the general
 51

price level. It describes the framework about the direct relationship between velocity of
money and price. The original foundations of this theory began to surface during the
historical debasements of the 15th, through the 17th centuries. The increased minting of
gold and silver into coins in Europe resulted into a rise in the inflation rate. It was this
development that provided foundation for the assumption that more money means more
inflation. Consequently, the hypothesis that the stock of money equals price times the
real incomes that is combined with the velocity evolved from these developments
(Thornton, 1802).

This was developed further by Irving Fisher in a simplified equation of exchange

expression: MV PT, where: M = the stock of money, V = velocity of money for all
transactions, P = average price level, and T = volume of transactions of goods and services
in an economy. According to Fischer’s thought, therefore, money is demanded for
transaction motive only. However, Keynes revised this theory and consequently stated
that money is demand for three main motives (i) transaction motive, (ii) precautionary
and (iii) speculative motive.

The transaction motive emanates from the classical and neo classical economic theories
of money demand (Pigou, 1917; Fisher, 1911)26. It points that money is demanded as a
medium of exchange to facilitate transactions. That is, by itself, money has got no intrinsic
utility. The transaction demand for money is largely dependent on the level of income
both on the individual as well as on the aggregate scale (Keynes, 1930, 1936). Although
there was no mention of demand for money in the original classical theory, the transaction
velocity of money circulation was stressed as seen in the “equation of equation,”
, which relates to the quantity of money in circulation ), a proportionate factor
known as the velocity of money in circulation, the price level of traded articles
and lastly the total number of transactions ( ) over a specified period of time. The neo
classical approaches ignored the role of interest rate as a factor affecting the demand for
money. For example, Marshall and Pigou contented that it was the uncertainty about the
future that influences the demand for money (Laidler, 1993, p. 53).

The precautionary motive is founded on the belief that sometimes an individual might not
be certain on the amount of money he might want or want to have in future. This creates

26
For more details, Schumpter (1954) and Goodhart (1997).
 52

a precautionary motive to hold money for unforeseeable expenditures. So, this motive
serves as a contingency plan to guard against the embarrassment of not being able to
transact or settle the unscheduled expenses during unforeseen circumstances27.

The speculative motive was propagated by the Keynesian monetary theory. This theory
postulates that money is an alternative to holding bonds (Keynes, 1936). So, according to
this theory, money is demanded for transaction, precautionary and speculative purposes.
The speculative demand for money is highly sensitive to changes in the prices of bonds
in the economy28. This implies that ceteris paribus, an increase in bonds’ price (that is,
when interest rates are low) induce people to hold less money and more bonds and vice
versa when the price of bonds fall.

Therefore, contrary to the classical theory, monetary policy actions affect output
indirectly via its impact on the interest rate. Most importantly, as earlier stated, the impact
to the real economy is not even certain. Rather, it depends on how investment responds
to the interest rate and the expenditure multiplier in the economy (Bilgili, 2001). The
effect of excess real money supply on the real expenditure in the economy has been
discussed extensively (Aghevli and Sassanpour, 1982; Hossain, 1995; Khan and Zahler,
1983; Prais, 1961; Swoboda, 1976).

2.9.2. The credit channel

The second channel of monetary policy transmission is sometimes referred to as the

banking and credit channel. There are two schools of thought about this channel; on one
hand, the classical- monetarist Economists stress that money is either narrow money (M1)
or broad money (M2). In this view, monetary aggregates play a vital role in determining
the price of assets, goods and hence affect the long-run inflation levels in the economy.
On the other hand, Bernanke and Getler (1995) believe that credit channel directly
impacts on both price and output level and eventually consumption expenditure (Mishkin
1996, p. 14-15; Loayza and Hebbel, 2002). This channel is related to the role of the central
bank in the monetary transmission process.

27
Keynesian approach to the money demand theory was well developed in Keynes (1930 and 1936).
28
Both the classical and neoclassical earlier works did not mention the importance of interest rate in the
demand for money theory. It is Keynes who convincingly elaborated and stressed the how imperatively
significant the interest rate sensitivity (Liquidity preference) for macroeconomic analysis.
 53

Monetary literature on the analysis of this channel are enormous. Such studies by Meltzer
(1969, 1970, 2001), Brunner and Meltzer (1972, 1988, 1990), Dotsey and Otrok (1994),
McCallum (1990, 1999, 2001, 2004), Christiano and Rostagno (2001) Nelson (2003,
2003) and McCallum and Nelson (2004) all site credit channel as the most significant
channel and thus plays a fundamental role in the monetary policy transmission (Kassim
and Shabri, 2009, p. 38). This channel functions in such a way that the monetary policy
actions and effects are transmitted to the nominal and real economy in two sub-channels:
the bank lending channel and the balance-sheet channels. These arise because of agency
problems in credit markets which are caused by the asymmetric information and moral
hazard challenges. The bank lending channel is expressed schematically as below.

M ↓ ⇨ BD ↓ ⇨ I ↓ ⇨ Y ↓ (2.8)

Where (M) = money supply, (BD) = bank deposits, (I) = investment expenditure, (Y) =
output and ↓ indicates policy action and its effects on the economic variables. The
implication is that when the central bank undertakes a monetary contraction action that
reduces money supply (M ↓) such as increasing the required reserve ratio, the banks’ loans
decrease (BD ↓ ) in response to the fall in the bank reserves. So, as the supply of loans to
the investors decrease, consumption and investment spending will decline (I ↓) and
consequently, output levels will decrease Y ↓ . Studies such as Bernanke and Blinder
(1988; 1988) are some of those that have demonstrated the importance of the lending
channel. With financial liberalization which enables financial institutions to access
relatively easy external funding, this channel tends to weaken (Mishra et al., 2012).

The balance-sheet channel functions through its effect on the net worth of the firms. It
specifically increases the adverse selection and moral hard problems since it lowers the
net worth of the business firms. This increased risk lowers the lenders’ desire to offer
loans and therefore decreases the investment and consumer spending.

2.9.3. The interest rate channel

This channel focuses on how the central bank policy rate influences commercial banks’
interest rates and foreign exchange rates relative to the neutral interest rate29. When the

29
The neutral rate relates to the rate that is required to bring about stable inflation levels and full
employment over the medium term.
 54

central bank sets its cash rate above the neutral rate, monetary policy is exerting a
contractionary influence on the economy. On the other hand, when the cash rate is set
below the neutral rate, then the central bank is exerting an expansionary influence on the
economy (McCririck and Rees, 2017).

However, although the central bank controls the nominal interest rates, it is the long-term
real interest rate changes that influences inter-temporal decisions regarding consumption
expenditures and labour supply. Consequently, the wealth positions of both borrowers
and lenders change in the overall economy (Yıldırım and Mirasedoğlu, 2015, p. 109). For
example, an increase in the short-term nominal interest rate leads to an immediate
increase in the longer-term nominal interest rates described by the expectation hypothesis
theory of the term structure. Since prices are assumed to be sticky in the short run, this
affects the real interest rate and so is the cost of capital. Thus, it is the real not the nominal
interest rate that impacts on the households as well as the business sector decisions of the
economy.

Similarly, a decline in the long-term real interest rate reduces not only the cost of
borrowing, but also encourages spending on durable commodities and investments by the
business sector. Subsequently, the increased investments and expenditure on durable
consumer goods boosts the aggregate demand and employment levels in the economy.
With the deregulation and efficient markets in the contemporary world, the effectiveness
of this channel has become contentious since households and investors cannot be kept
ignorant for a long of the consequences of monetary policy (Boschen, 1992).

This can be summarized in the following expressions.

M ↑ ⇒ r ↓, I ↑ ⇒ Y ↑ (2.9)

Where M = money stock, r) = real interest rate, (I) = investment (Y) = output and (↑)
shows the policy action and its subsequent effect on the economic variables. This
expression implies that an expansionary monetary policy causes the real interest rate to
decrease and so lowers the cost of capital. The lower cost of capital induces a rise in
investment expenditure on both capital and durable consumer goods according to the
Keynesian monetary theory (Mishkin, 1996, p. 36; Eroğlu, Aydın, Kesbiç, 2016, p. 171).
The ultimate effect is an increase in aggregate demand and output as indicated by (Y↑)
(Horvàth and Maino, 2006). However, it is important to note that there is some time lag
 55

in the transmission process through the interest rate channel. This is caused by the
commercial banks’ internal asset mechanism processes.

When the central bank implements a monetary policy, the development first affects the
financial sector before eventually affecting the price levels and the real output. In other
words, as the bank rate affects the interbank money markets, the banks’ deposit interest
rates are affected and so are the credit interest rates. Such interest rate changes are
eventually transmitted from the monetary to the real sector through their effects on
consumption and investment decisions of the public and private sectors. Since customers
earn interest income on their deposits, the effect of interest is related to the role of interest
as an income for the customers earned on their deposits (income effect). Similarly, the
credit interest is related to its role as source of customer financing (the substitution effect).
As noted earlier, the interest rate effect on investment demand affects the business sector
in the economy since interest is a cost of capital.

2.9.4. Asset price channel

The fourth monetary policy transmission channel is the asset price channel. This channel
is normally explained based on Tobin’s q (1969) theory of investment and Ando and
Modigliani (1963) life cycle theory of consumption whereby an expansionary monetary
policy which entails higher equity prices causes the investment projects to become more
attractive. Consequently, the wealthy class raises their expenditures on both consumer
goods as well as investment and in effect the aggregate demand in the economy raises
(Kesbiç et al., 2016). Therefore, during the monetary policy contraction periods, there is
need to re-establish equilibrium to avoid the fall in equity prices and vice versa during
boom (Ireland, 2005).

Under this channel, there are two conduits through which monetary policy is transmitted.
That is, the Tobin’s q theory and the wealth effect theory and these are expressed as
follows:

M↓i↑ p ↓⇒q↓⇒ I ↓⇒ Y↓ (2.10)

Where M = money stock (money supply), (i) = nominal interest rate, p ) = equity
prices (q) = ratio of the market value to the replacement cost of capital, (I) = investment
and (Y) = output. From the above expression, money supply decreases in the economy
 56

because of monetary contraction policy causes nominal interest rate to increase. This
implies that individuals would have less money than they would otherwise want during a
given time.

Therefore, to smooth their consumption, they sell off some of their assets such as
securities. Consequently, this decreases the demand for stock and their prices fall. Such
decreases induce a fall in the q value of firms, prompting business enterprises to reduce
their investments and hence causing a fall in output production. Essentially the ratio of
Tobin’s q ought to be greater than unity to stimulate investment expenditure because this
would imply that capital is valued more in the open market that it costs to replace it in the
firm (Parasız, 1999, p. 302; Brainard & Tobin, 1968, 1977).

Under the wealth effect, monetary policy transmission is conducted through wealth effect
on consumption. This is based on life-cycle hypothesis model whereby consumption
spending is determined not by the current incomes as proposed by Keynesian theory but
rather by the life-time resources. This implies that if the value of wealth increases, this
would also increase the consumption expenditures of both households and firms.
Similarly, if the value of wealth decreases, consumption and investment expenditure of
households and investors also decreases (Öztürk, 2011, p. 291). The following schematic
expression is presenting the mechanism as explained above:

M ↑⇨ p ↑⇨ w ↑ ⇨ ↑⇨ Y↑ (2.11)

M ↓⇨ p ↓⇨ w ↓ ⇨ ↓⇨ Y↓ (2.12)

Where M = money stock (money supply), (p ) = equity prices, (w) = wealth of equity
owners, ( ) = expenditure on consumption and investment, (Y) = output levels and The
Monetary contraction causes the value of stock price to decline. So, since most of the
financial assets are common stock, the decrease of stock price leads to decrease of wealth.
Therefore, households will decrease their consumption expenditures and because of the
decrease in aggregate demand, output levels will fall (Cesur, 2016).

Also, the Exchange rate plays a significant role in the monetary policy transmission
mechanism. For, the interest rate parity theory asserts that the balance of interest rates
between two countries is approximately equal to the rate of change expected between
their currencies (Taylor, 1995). This implies that as the rate of interest increases, the gains
 57

from the foreign assets become bigger as compared to those of local ones. Therefore, the
local currency appreciates following an increased demand for it. In contrast, when the
monetary authority undertakes a monetary policy expansion, the interest rate decreases,
asset returns decrease in terms of the local currency and henceforth the currency
depreciates (Yalta, 2011, p. 193-195).

2.9.5. The expectation channel

This is the fifth and the last channel through which monetary policy transmission is
conducted. The explanation of this channel is based on the rational expectation hypothesis
which states that since forecasting errors are purely random, they cannot have any
systematic component and henceforth business agents’ expectations are forward looking
and are correct on average. Accordingly, these agents cannot be surprised systematically
(Muth, 1961). Based on this theory, the modern macroeconomic literature postulates that
both household and firm expenditures are affected by their expectations of the future as
propagated by the Lucas-critique (Lucas, 1976). The implication is that current
consumption and investment expenditure decisions are not determined by the current rate
of interest alone but are as well shaped by the future exchange rate and interest rate
expectations of consumers and investors respectively (Moore, 2016).

The rational hypothesis theory forms the basis upon which the new classical school of
macroeconomic thought is developed. As mentioned earlier, the new classical
macroeconomic postulations are somewhat like the monetarist theorists at least
qualitatively. Thus, the monetary policy implication of this argument is that the new
classical Phillips curve also provides an inflation-unemployment trade-off for as long as
inflation comes as a surprise. Most importantly, the shape of the curve is vertical and
hence only supply side policies result into real effects on the economic variables in the
long run (Lucas, 1972, 1973).

Similarly, the current level of inflation is determined by the expectations on the future
rate of inflation. This explains the logic behind central banks’ periodic publications of
their expectations concerning important macroeconomic variables. Such publications are
a yardstick upon which the economic actors make critical investment and consumptions
decisions, especially on durable commodities (Öztürk, 2011; Hopkins et al., 2009).
 58

Undoubtedly, however, expectations are associated with a lot of uncertainties due to the
problem of asymmetric information. This imperfect knowledge of the money market
breeds adverse selection and moral hazard challenges that are rampant under the
conventional financial and monetary system. Adverse selection relates to a wrong
decision by a financial institution that occurs in the financial market under a situation in
which the creditor is unable to distinguish between a low risk and a high-risk investment
project before funding it. On the other hand, moral hazard relates to the financial market
situation whereby the financial institution pursues the debtor to determine whether the
borrowed funds were invested as planned or not (Erdem, 2016, p. 79, 88).

Figure 2.3. The conventional monetary policy transmission mechanisms summarised

Source: Warjiyo (2003).

 59

CHAPTER THREE

AN OVERVIEW OF ISLAMIC CENTRAL BANKING AND

MONETARY POLICY SURVEY

3.1. Introduction

This section covers an overview of the main aspects of Islamic central banks’ operations
and monetary policy systems. After a brief history to the Islamic central banking and the
monetary system, the history of the central banking and the Islamic monetary system is
presented. The Islamic concept of money, The aims, targets and goal of Islamic central
banking and monetary policy, the roles and functions of the central bank, the basic Islamic
banking, financial and monetary policy principles. The Interest rate perspective and why
it is prohibited under Islamic economic system, a comparison of the contemporary
monetary and financial practices of the Muslim countries, with the true Islamic monetary
ones and those of the convention system. Finally, a summary of the major differences
between the two monetary and financial systems and conclusion is made.

3.2. History of the Islamic central banking and the monetary system

Unlike the conventional central banking system whose history dates back in the 17th
century, Islamic central banking is a very recent phenomenon and hence plausible to
argue that it is still in its infant stage of development. The case in point is that from the
early days of Islam through the golden age of the Islamic caliphate periods, there was no
mention of Islamic monetary system as we know it today. Monetary policy means of
regulating money supply and inflation rates through rule-based and discretionary
measures were never practiced as there were commercial financial institutions that is
systematic as the banking institutions today.
 60

Specifically, during Prophet Muhammad’s (PBH) there was neither a central bank nor a
commercial bank in the world. The only documented closest monetary institution at the
time with in the new Muslim state was the state treasury (Baitul mal) and was charged
with three main functions; collection of taxes for government facilitation, collection of
zakat from the rich and its distribution to those financially disadvantaged, and lastly
building infrastructure using waqf property, infaq extra (Hossain, 2009).

Islamic history books, however, show that there was some form of banking activities like
modern banking transactions that have existed since the early days of Islam (Omar, 2001,
pp.101-10). These banking activities later developed and expanded throughout the then
rapidly developing Islamic Empire. For example, sukuk as a method of payment was
widely used to pay state employees and soldiers during the 4th Ummayad Caliph, Marwan
bin Al Hakam in the very first century of Islam (Takahashi & Nasser, 1996, p. 9). By the
4th century, bank related institutions known as dawawin aljahabidhah which were
managed by sarrafiin had spread across the Islamic caliphate (Al-Djahshiyari, 1938; Al-
Hamdani, 2000; Chachi, 2005; Durî, 1991).

The sarrafiin played such roles including working as skilled money examiners, financial
clerks, treasury receivers, money changers, government cashiers among others (Chachi,
2005). During the Abbasid dynasty (750-1258AD), commercial activities thrived and
facilitated the further development of dawawin aljahabidhah (kind of banking
institutions) through to the end of the 11th century. These banks’ source of funds was
largely from the profits they made and the private as well as state deposits. To ensure a
firm development of the financial system, schools, and colleges where banking and
financial rules and regulations were taught were established. All the above developments
serve to confirm the assertion that Islamic banking is as old as Islam itself (Nasser 1996,
p. 15–16).

However, as the Islamic empire started declining in the 12th century, the role of sarrafiin
and the Islamic commercial and finance activities got distorted. Despite the concerted
efforts by the Ottoman Empire to revive the once very progressive sector, the decline
continued. When parts of the Islamic empire began to adopt the western mode of banking
in the 19th century such as Bank of Egypt (1856) and the National Bank of Egypt (1898),
the final collapse of the Ottoman Empire in the early years of the 20th century could not
be avoided (Nasser, 1996).
 61

As a revival effort, the idea of modern Islamic finance was initiated as soon as Muslim
majority countries started attaining their independence around the middle of the 19th
century. By 1962 the first Islamic bank (Tabung Haji) was established in Malaysia and
was aimed at helping Prospective pilgrims to save money for Hajji Expenses. This was
followed by the Mit Ghamr Bank in Egypt in 1963 (Iqbal and Molyneux, 2005).

However, the institutionalization of Islamic banking was never achieved until the 1970s,
when the first global network of Islamic banks emerged. The most notable Islamic banks
that sprung up by 1970 included the Nasser Social Bank Cairo (1972), Islamic
Development Bank (IDB) (1975), Dubai Islamic Bank (1975). Also, the Kuwait Finance
House (KFH) (1977), Faisal Islamic Bank of Sudan (1977) and Dar Al-Maal Al-Islami
(1980) among others. This implies that much as the Islamic principles of banking and
finance were laid down in the Holy Quran over 1400 years ago, the actual practice of
Islamic banking and finance in the form we know it today only began to take operational
sphere in the last half of the last century.

The evolution of the institutional frameworks of modern Islamic banking and finance
industry since its inception in the early 1960s is summarised as below.
 62

Figure 3.1. Evolution of key institutional frameworks of modern Islamic banking and finance industry

First Islamic Dubai Islamic bank Iran AAOIFI established IFSB introduces Islamic assets
Fiqh council of the
bank established under introduces to act as a nodal body standard on grew at 15%
OIC declares Takaful
established in special law 100% Islamic advising on the Base111 and exceeded
as fully Islamic
Egypt. pioneering Islamic banking standards to be compliance for USD 1
paving way for the
banking in the system. followed by Islamic Islamic trillion in
Islamic insurance to
region. Institutions institutions 2016
flourish.
worldwide.

1983
1975

1984

1985

2005
1963

1989

2002
1991

2007

2016
IDB established to foster Total Islamic
Sudan launches Sudan’s banking IFSB established
economic development and social assets aggregate to
Islamic banking system becomes inn Malaysia. The
progress of member countries and Malaysia passes USD 300 billion,
comprehensive 100% Islamic organizations growing at the rate
Muslim communities. IDB enhance stability
participates in equity capital and legislation on of 10-15% for a
Islamic Finance of the industry by period of more
grants loans for projects in issuing standards
member countries than 10years.

Source: Based on World Bank (GFSR, 2017).

 63

3.3. The Islamic concept of money and its role

The concept of money, finance and real economic variable in Islam cannot be discussed
exclusively without considering the broader Islamic worldview. It is this unique
conceptualization which has always given humans a distinctive way of understanding,
analysing, and dealing with complicated and sophisticated world-systems in an objective
framework through time and space (Choudhury, 2005). The Islamic worldview emanates
from the universal and ontological law of unity of knowledge which is derived from the
single most important pillar of Islam which also doubles as the first article of faith known
as Tawheed (Oneness of God). The implementation and practice Islamic banking and
finance cannot be successful unless taken in the wider concept of Islamic world view.

Figure 3.2. The concept of money in the general methodological framework of Islamic
worldview

Hereafter

Community and
sustainability

Simulacra of evaluation
based on spiritual and

Evaluation of wellbeing criterion in terms

of unity of knowledge by circular
causation between variables.

Formation of World-system. The unity of

knowledge with multi-systems.

Epistemology

Monotheism (Tawheed) as a primal of ontological law

Source: Choudhury, 2016, p. 368-402 but modified by the researcher.

 64

Based on the generalized methodological framework above, Choudhury (2016) defines

Islamic money as an economic contravention of the unity of knowledge in the domains
of interactively integrating time followed by the evolutionary learning processes over the
knowledge, space, time, and events along the trajectory of history. Islam thus bases on
the social and economic specie to make sense of the concept of money. So, contrary to
the conventional system, the Islamic view of money in the inter-temporal sense is based
on the intrinsic utility unit value, such as gold and silver. In short money in Islamic
perspective must be backed up by a real valuable good like gold, silver, among other
precious assets since it does not possess value by itself. It is on this basis that all Islamic
transactions are asset and service backed with no respect to the time value of money
emphasized under the conventional monetary system.

The Islamic banking theory affirms that money by itself has no inherent value, cannot be
traded but only acts as a store of value and a medium of exchange as defined by Ghazali
(Hassan, 1998). Therefore, once considered for monetary policy purposes, the changes in
the rate of the policy variables are driven by actual changes in the stock because of
changes in the variables (Choudhury, 2018). So, the asset and service backed feature of
Islamic money does away with the pyramidal money-lending schemes with their
associated monetary losses because of inflation.

In other words, money creation and money market volatility that characterize the
conventional banking sector is easily kept in check when an Islamic monetary system is
adopted, both in form and substance. Once achieved, the stability of money value reflects
price stability, which is the main goal of monetary policy (Hossain, 2009; Soemitra,
2019). Consequently, pursuance of a country’s development goals such as sustainable
economic growth, low unemployment levels among others becomes relatively easier
(Mujahidin & Muhamad, 2019).

In terms of credit finance, as noted earlier, under fiqh wal mu’amalat (Islamic
jurisprudence), money is not considered valuable by itself. It is simply a medium of
exchange which is treated as potential capital. Therefore, it requires the service of the
entrepreneur to activate the potentiality into actuality by using it productively (Uzair,
1980). Money is looked at from its microeconomic viewpoint as asset-backed and linked
to actual projects and assets when being considered for its monetary role in the Islamic
perspective. This means that unlike the conventional monetary that is based on nominal
 65

changes in the interest rate, the asset backed nature of money perceived by Islam relates
to the real economy and thus less volatile compared to the former. It is therefore arguably
more market-oriented and more effective in combating market inefficiencies (Greenfield
& Yeager, 1983)

As a medium of exchange and store of value, Islam asserts that money must be converted
into financial instruments to ensure resource regeneration. Therefore, like in the previous
ages, by principle, money cannot be held back through hoarding or bank-saving to earn
interest incomes but instead it must be continuously mobilized for investment (Erdem,
2019). To encourage investment and re-investment for economic growth through
production as opposed hoarding and or bank-saving, a 2.5% rate of zakat is levied onto
the incomes that reach Nisab30 as an obligation (Zehnder, 2014). A lender cannot and
should not be entitled to any returns in the Islamic perspective (interest as a cost of his
funds “capital”) that precedes productivity. Specifically, money in Islamic viewpoint
cannot attract an earning by itself and so incomes received as interest payments and
receipts from lenders and depositors is categorically considered haram (unlawful). A
legitimate income ought to be earned from one’s labour, production and trade (Erdem,
2017, p. 100).

Allah says:
“Oh you who have attained to faith! Do not gorge yourselves on usury, doubling and re-
doubling it - but remain conscious of God, so that you might attain to a happy state. (Aal-
Imran, 130).

Also, “Allah deprives interest of all blessing, whereas He blesses charity with
growth. Allah loves none who is ungrateful and persists in sin.” (Al-baqarah, 276).

In his explanation of the impact of sadaqat /zakat (charity) to growth of a society, the
Prophet (PBH) laid down an income multiplier effect when he stated thus.

“Whoever gives charity equal to a date from good (halal)earnings – for Allah does
not accept anything but that which is good – Allah will take it (in His right hand) and
tend it for the one who gave it as any one of you tends his foal, until it becomes like a

30
Nisab relates to the minimum amount of wealth from which zakat is levied. So, it is a zakat measurement
tool that differentiates the affluent from the poor members of society (Al Qaradhawi, 1999; Majah, 1952).
 66

mountain.” (Buharî, 2000, Zakat: 8; Muslim, 1979, Zakat: 63; Muvatta, 2000, Sadakat:
1; Tirmizi, 2000, Zakat: 28; Nesei, 1981, Zakat: 48).

The above standpoint is the divine ruling as confirmed throughout the previous scriptures
and past generations. So, long before Islam came to light; passed divine scriptures and
generations vehemently condemned interest rate charging as an “economic vice”. For
example, the Bible categorically castigates interest charges where it says:

“Lend freely, hoping nothing thereby” (Luke 6: 35).

Also, the Greek philosophers, such as Plato, St Thomas, Aristotle, among others preached
against interest and considered its charging and giving as the most hated “sort of retail
trade” because it makes a gain out of money itself without taking into account the natural
object of it as a medium of exchange (Armstrong, 1987).

Table 3.1. Comparison of the Islamic and conventional concept of money

ISLAM PURPOSE CONVENTION
Yes Medium of exchange Yes
Yes Purchases goods and services Yes
No Commodity Yes
No Loan to make profit Yes
Source: Abdul (2016).

3.4. The functions of Islamic central banking

Although Islamic economics has undergone dramatic development since the last quarter
of the 20th century, the available literature shows that there is a general lack of research
interest in the field of Islamic monetary policy (Yusof et al., 2009). Most of the studies
have tended to focus on the development of Islamic finance products that are deemed
compliant to Sharia as per the Accounting and Auditing Organization for Islamic
Financial Institutions (AAOIFI) standards.

Generally, the functions of the central bank under the Islamic economic system remain
somewhat like those in the conventional economic system (Ahmed, 2008). The role of
fractional reserve requirements and other monetary instruments which do not involve
interest rates are equally valid under an Islamic monetary system much as some
modifications are considered. Many Islamic economic scholars today are increasingly
 67

getting inclined to the view that fractional reserve system that allows commercial banks
to make money out of “thin air” (Fiat money creation) is null and void under the Islamic
monetary system (Chapra, 1985).

Additionally, Chapra (1985) agrees with other Islamic economics scholars that the
functions of the Islamic central bank remain generally the same as in the conventional
system. He, however, adds another critical and fundamental function of the central bank
in an Islamic economy; the need to ensure socio-economic justice and equitable
distribution of income and wealth. After all the central bank works on behalf of an Islamic
government that is obliged to maintain justice and prevent unfairness of all sorts in society
(Kozak et al., 2014). Chapra also backs the adoption of the existing quantitative
instruments such as statutory reserve requirement, credit ceilings, moral suasion, and
proposes a modification in the open market operations to be based on equity rather than
bonds and profit and loss sharing ratio to replace the bank rate policy (Chapra: 1996, p.
23).

3.5. Goals, Objectives, and Targets of the Islamic Central Bank

The principal goals of monetary policy management in an Islamic system is to achieve (i)
socio-economic justice and equitable distribution of income and wealth, (ii) economic
well-being with full employment and optimum rate of economic growth and, (iii) stability
in the value of money. All these are pursued in the framework of price stability
(Mujahidin, 2019; Siddiqi, 1996; Chapra, 1985, p. 34)31. But to achieve those goals a
stable macroeconomic system is a necessary precondition. So, the Islamic central bank
pursues price and financial stability.

In other words, like in the conventional system, the sole objective of monetary policy in
an Islamic environment is to achieve price stability (Hossain, 2009). Earlier on, there
were arguments that the monetary authority could pursue multiple goals. However, in
recent studies, it has been shown that consensus is building around a single goal strategy
as opposed to multiple strategies in monetary policy management. This is because

31
Other sources include Meilina, S., et. al. (2017). Kebijakan Moneter Dalam Ekonomi Islam. Pekalongan:
IAIN Pekalongan. p. 6-7, Wahyudi, A. (2013). Kebijakan MOneter Berbasis Prinsip-Prinsip Islam. Justicia
Islamica, 10(1). p. 62, Chapra, U. (2000). Sistem Moneter Islam. Jakarta: Tazkia Cendikia. p. 3.
 68

pursuing multiple goals over-burdens and compromises the independence as well as

reliability of the central bank (Orphanides, 2014).

According to Hossain (2009), the Islamic central bank achieves the monetary policy goal
by targeting inflation which is done by keeping a close eye (supervision) on the
performance of the economy. This is macroeconomic performance of an economy tends
to improve when its monetary authority pursues inflation targeting compared to other
monetary policy options (IMF, 2006). Essentially price and financial stability is the main
driver of economic growth which bring about sustainable balance of payments position
(trade balance). Therefore, like in modern conventional central banking, macroeconomic
stability in an Islamic economic system is considered critical for maximization of
investments, foreign-capital inflows, combating unemployment and income inequality
problems and ultimately improving the general wellbeing of all people in the community
(Chapra, 2000; Saud et al., 2019).

Macroeconomic instabilities such as recession and depression cause economic

inefficiency and distress on the entire poor cohorts. However, it impacts much harder on
the welfare of the larger percentage of people who are the poor members of society. So
since the well-being of an Islamic society depends on the equitable distribution of income
and wealth through taxation and alms giving (zakat) as an instrument of poverty
reduction, sustainable economic growth is considered fundamental from the Islamic
perspective as much as it is under the conventional system (Mulkiaman, 2016).

3.6. Islamic banking, finance, and monetary policy principles

Central banking and monetary policy from the Islamic perspective cannot be appreciated
without a basic understanding of the Islamic banking and financial system. Therefore, the
tools of Islamic banking and finance are discussed before the monetary policy principles
are explained. Although much of the Islamic economic literature emphasizes five Islamic
banking and finance principles as stressed in such works (Lewis and Algaoud, (2001), Al
Amine (2016)), in the general sense, there are six foundational principles of Islamic
banking and finance that differentiate the Islamic system from its conventional
counterpart. These are briefly explained below. It should, however, be noted that whereas
the first four are prohibition-related principles, the last two are positive measures intended
to ensure social-economic justice in the society (KPMG, 2006)
 69

3.6.1. The prohibition of interest (riba /usury)

Riba is an Arabic word that is defined, literally, to mean an increase, addition, excess,
(Saeed, 1996, p. 20). Schacht (1964) technically it relates to a special case of enrichment
which is unjustified. Formally, it means gaining monetary value without counter
monetary value from the counter party in a contract. Any incremental and exchange of
anything of value over and above the principle received from a sale contract, during
repayment period of the loan is considered riba (Karaman et al., 2006, p. 130-131).
Accordingly, any financial and monetary transaction that is based on the payment or
receipt of interest of any amount is strictly prohibited (Usmani, 2007).

Therefore, the fixed return which is the core or the foundation of financing operations
under the conventional economic system is not permissible in the Islamic teachings under
Fiqh al Muamalat shari’ (Mollah et al., 2017). This is because it is considered a form of
exploitation and unjustified self-enrichment at the expense of others as a way of doing
business. This effortless enrichment of oneself at the expense of the vulnerable members
in any society undermines the very essence of sharia that aims at preserving and
upholding the dignity of all human beings (Schoon, 2016). This thus implies that profits
from indebtedness and the trading of debts are considered unethical and henceforth
unacceptable. This is the consensus of majority Islamic jurisprudence (Fukaha). That is,
they maintain that interest is absolutely prohibited irrespective of the purpose and form
(Kahf, 2002).

This debate has continued despite an early effort by Muslim jurists across all schools of
law to explicitly state that there is a unanimous interpretation and understanding among
all schools of Islamic thought and civilization on the term riba to mean interest in all its
types and forms as mentioned in the Council of Islamic Ideology (CII) Report (1983).
The main reason for this has been the unwavering desire to define and re-define the
meaning of the word riba / usury (Amrial et al., 2019).

It is important to note that like the prohibition of intoxicants which had been entrenched
in the social life, interest rate charging too followed a gradual prohibition process with
more than ten different verses, most significant of which include the following (Quran;
30:39, Quran, 4:16, Quran, 3:130 and the final verses that sealed its prohibition are Quran,
2:275-280), which were revealed towards the end of the revelation. The essence behind
 70

this prohibition is that Interest rate charge does not only amount to injustice and
oppression in society but also amounts to disobedience of Allah and His messenger (PBH)
(Erdem, 2017).

The implication here is that the prevalent monetary policy that is based on the payment
of an overnight policy rate is null and void under the Islamic monetary framework.
Surprisingly, the Muslim majority countries that are making significant strides towards
Islamisation of their economies continue to pursue this very type of monetary
management. Besides there has been a growing recognition from the conventional
economic scholars that interest rate based monetary management has always been
responsible for the business cycles and not very effective in the determination of savings
and investments (Siddiqi, 1983).

3.6.2. The prohibition of uncertainty and speculative practices (gharar and maysir)

The concept of uncertainty (gharar)32 in the economy today can be interpreted to mean
the zero- sum game (El-Gamal, 2001, p. 2). There are three kinds of gharar, namely,
excessive (gharar al-kathir) which nullifies the transaction, minor (gharar yasr) which
does not nullify the transaction and therefore tolerated and (moderate), gharar
mutawassit) which falls between those two categories.

The Quran stresses this prohibition in different parts for example, (Quran, 4:29, 2:219,
5:90-91). Buying of money at the present period and selling later at a speculatively higher
price is considered illicit trade under the Islamic financial system and thus prohibited
(Mannan, 1986, p. 289).

Similarly, any speculative trade deal contracted based on speculation (gharar) such as
options and futures in the stock markets today is null and void as stressed by the consensus
of Muslim jurists (Dhareer, 1997, p. 18–19). This was further emphasized by a number
of traditions of the prophet as found across prominent ahadith books including Muslim,
Ahmad, Abu Dawud, Al-Tirmidhı, Al-Nasa’i, Al-Darami and ’Ibn Majah. Abu Hurayra
specifically narrated a hadith which highlights this prohibition by the Prophet (Peace Be

32
Gharar is defined by Al-Sarakhsi (Hanafi School) as “a contract whose consequences are hidden". The
Shafi’I School as stated by Al-Shıraazı defines it to mean any business dealing whose nature and
consequences are hidden" According to Ibn Taymiya (Hanbali School), Gharar is that whose consequences
are unknown” Al-Zuhaylı (1997, vol.5, p. 2408-3411).
 71

upon Him) prohibited pebble sales and the gharar sales (El Gamal, 2001, p. 2). Any
contract whose risk is too high is considered among the forbidden gharar (Razali, 2012).

Similarly, gambling is strictly forbidden (Siddiqi, 1985). Otherwise put, Islam strongly
commends contractual certainty to avoid speculation and gambling tendencies. The
longest verse in the holy Quran (2:286) clearly lays down the details of contracts.
Accordingly, convention contracts that are based on contractual uncertainties and
speculative elements such as futures, options, interest transactions among others are ruled
out under the Islamic scheme of monetary system. However, commercial uncertainty on
whether a business will be profitable or not is acceptable provided that the contracting is
backed up by a real asset such as capital equipment machines extra or service such as
labour. In fact, this is instead considered a risk sharing feature as opposed to an uncertain
transaction.

3.6.3. Prohibition of haram (unlawful) earnings

In a general sense, halal and haram refers to the permissible and impermissible things in
Islam, respectively. The determination, however, of halal and haram rests on the
authority of the creator. Accordingly, Al-Qaradawi (2001) bases on Holy Quran (31:20)
to infer that the criterion for the determination of lawfulness and unlawfulness of any
matter explicitly rests with Allah as laid down in Quranic injunctions. A comprehensive
literature review on the subject matter shows that Muslim scholars have endeavoured to
differentiate between haram and halal products and affairs (Salehudin, 2010).

Therefore, no financial and or monetary transaction should be directed towards illicit

economic and financial activities which the Fuqaha (Islamic jurists or scholar) has
pronounced unlawful (El-Gamal, 2001). So, intoxicants and gambling industries, as well
as all enterprises for which financial leverage (indebtedness) would be deemed excessive
(including conventional banks) is declared null and void as highlighted by the Holy
Quran. Allah says:

“Oh you who believe! Intoxicants and gambling, (dedication of) stones, and (divination
by) arrows, are an abomination, of Satan´s handwork: eschew such (abomination), that
you may prosper”. (Al- Ma’idah, 90).
 72

3.6.4. Prohibition of hoarding of coins

While Islam lays no limit on profits that one can earn from his shari’ compliant productive
activities, it strictly requires that all the goods produced should be presented to the market
so that the prices are determined by the free market forces of demand and supply.
Therefore, hoarding of goods which reduces the circulation of money in the market and
hence forth creates an artificial scarcity (Chapra, 1985). Hoarding of goods is considered
as a dishonest and an unfair way of earning incomes which is contrary to an indispensable
goal in Islamic economics as the principle of honesty and fairness during measurement
of goods and services as laid down in different parts of the Holy Quran for example, 7:85,
11:84-85; 17:35 and 26; 181, among others.

The Quran thus strictly forbids it because if leads to the suffering of the larger society due
to the artificial demand. Those who hoard goods are warned of a severe punishment on
the day of recompense (Qur’an, 9:35). Also, the prohibition is because hoarding affects
the velocity and destabilizes the value of money which is crucial in an Islamic economy
where money serves as a store of value. Thus, this prevention wealth hoarding and aims
at motivating owners in investing and circulating their wealth. In a wide range of verses
explicitly favour commercial and trade activities for promotion of economic growth and
improvement of the wellbeing of society (Holy Qur’an, 10: 67, 14: 33, 16: 12, 17: 12, 28:
73, 45: 12, 61: 73–77, 62: 10, 78: 11, among other verses.

3.6.5. Profit-and-Loss Sharing (PLS) obligation

The original concept and spirit of the Islamic financing system is in favour of risk sharing
otherwise known as equity participation. This is the basic principle for doing investments
(Ahmad, 1982, p. 478). The members in equity-based financial contracts share the risks
and benefits derived from such investments and transactions (Siddiqi, 1983). Profit and
Loss Sharing (PLS) converts the relationship from borrower and lender to business
partners and some cases into shareholders who share profits and incur losses from their
investments (Kaleem, 2000).

Accordingly, equity participation promotes creativity and innovativeness in doing

business as the focus is on the business itself (Kortum and Lerner, 2000; Engel and
Keilbach, 2007). This is not the case with the interest-based financing schemes in which
 73

the attention is strictly paid to the loan repayment schedule. Equity participation is the
ideal financing strategy for the small and medium scale businesses (SMEs) which require
both time and money to become profitable (Gatchev, et al., 2009). By extension, this is
the ideal financing strategy for the developing economies which are generally
characterized by small and medium scale businesses (SMEs).

The ratio of profit sharing may be determined by the central bank (Uzair, 1980). Some
scholars, however, find this determination as undue interference in private transactions
and therefore suggest that this is determined by the free market forces of demand and
supply to ensure efficiency (Usmani, 2002).

3.6.6. Asset-backed obligation and principle

Financial transactions should be based on a tangible, identifiable underlying asset and or

service (Al Amine, 2016). Thus, Islamic teaching encourages financing economic
activities through asset-based and asset backed mechanisms as opposed to the
monetisation of the economy based on interest charges and earnings.

3.7. The basic Islamic banking and financial tools

Commercial banks function as financial intermediaries that attract financial resources

from individuals and institutions that have surpluses and redirect them to those in need of
financial help to support their business activities. Islamic banks are not any different from
this noble service. However, what differentiates them from the conventional banks are
the tools they employ. All their services must strictly observe the above mentioned
Islamic financial guiding principles.

So, different Muslim majority countries have developed different financial contractual
instruments which are categorised into two broad forms: intermediation contracts and
transaction contracts. The former category relates to those that facilitate transparent and
efficient execution of transactional contracts. On the other hand, the latter are those that
govern real sector transactions and the general financing of economic activities in an
economy. These two categories form the foundation on which several contracts and or
financial instrument are developed as illustrated the following figure.
 74

Figure 3.3. The breakdown of Islamic financial system

Islamic financial
system

Intermediation contracts Transactional contracts

Mudarabah Qardh-hassan Asset based Equity

securities participation
Kafalah/
Aqd-daman

Amanah Trade Collateralized Musharakah

financing securities (sukuk)
Takaful

Wakalah
Murabahah Bay’ Bay’ Ijarah Istisna’
salam mu’ajal
Ju’alah

Source: El-Hawary and Dahlia (2004, p. 56).

From the above figure, the categorisation of Islamic contracts is easily demonstrated.
The contracts under the intermediation category include Mudarabah, kafalah, amanah,
takaful, wakalah, ju’alah among others. These as mentioned earlier play an important
role of facilitating an efficient execution of transactional contracts. Services that are
provide under these contracts include brokerage (under wakalah), custodial (under
amanah), consultancy (under ju’alah), insurance (under takaful), guarantee (under
kifalah), extra (Ayoub, 2002).

For the transaction contracts, they facilitate financing of economic activities through trade
and exchange. Commodity trade is the basis for the core transactional contracts. That is
trade must be backed by a real commodity or economic activity. Such contracts as
murabahah, bay’ salam which create instruments to provide financing of economic
ventures at varying maturities are some of the examples under this category (Khan, 1994).
 75

Under the Islamic economic order, an economic dealing must be undertaken in a

contractual form as elaborated by the longest verse on the Holy Quran (Al Baqarah, 282).
Although some of the contracts in the above figure are disputed by some Islamic scholars,
they continue to develop and are being practiced in countries where they are accepted as
shari’ compliant. Nevertheless, the core financial instruments take one or more of the
following forms: musharakah, murabahah, mudarabah, ijarah, istisn’a (Kaynak &
Whiteley 1999). These are broadly categorized into three main groups as illustrated in
Table 1 below.

Table 3.2. Islamic banking and finance instruments

Participatory contracts Fee-based contracts Debt-based contracts
Bank and customer co-invest in Bank charges a fixed fee in Customer undertakes a debt
a partnership agreement e.g. exchange for a service obligation to the bank backed by
Mudarabah provided to the customer e.g. an asset e.g.
Musharakah Wakalah Murabahah
Diminishing musharakah Ijara Salam
Sukuk Istisna’a

Source: Oliver Wyman (2009).

From the table above, the tools stated are defined and explained as follows.

3.7.1. Mudarabah (joint venture financing)

This is a partnership-like form of contract in which one partner (rabb al-mal) finances an
agreed upon project while the other party (entrepreneur/ mudarib) manages it (Hawary et
al, 2004 and Al-Omar and Abdel-Haq, 1996). Madarabah instrument falls under the same
category with the musharakah instrument, though the former mode of financing does not
necessitate the creation of a company.

In terms of the banking sector, the financial institution plays the role of the rabb al-mal
by providing all the required capital and the customer (entrepreneur) takes responsibility
for the management of the project. Many scholars, however, limit this mode of financing
to self-liquidating transactions only (Ali, 1992). While profits are shared according to the
pre-agreed upon ratio between the bank and the customer, the losses are born by the bank.
The entrepreneur only loses his efforts once proved that the loss is not out of negligence
and miss management on his side.
 76

3.7.2. Musharakah (Joint venture).

This is a profit and loss sharing form of business partnership in which participants
contribute capital and there after share the risks as well as reward that accrue to their
investment venture. The ratio of profit sharing is agreed upon between or amongst the
partners at the time of contracting their project. Although all the partners have the right
to take part in the management of the venture, they are under no obligation to undertake
their right to participate (Hawary et al, 2004; Usmani, 2002 and Chapra, 2007). So, the
profit is agreed upon mutually between or amongst the parties involved. The losses are
however shared according to the percentage of the capital contributions of individual
parties involved in the contract. Partners therefore are motivated to invest only in
profitable projects to mitigate the risk of incurring losses.

In case the client intends to purchase the good at the end of the contract period, they enter
a different form of musharakah known as diminishing musharakah. Under this mode, the
percentage share of ownership in the venture of one party (Islamic bank) keeps on
diminishing as that of the customer keeps increasing until he/she takes full ownership of
the project at the end of the contractual period. This mode of financing is instrumental in
aiding financially weak members of society to own expensive durable goods like houses,
cars, agricultural machines extra.

Under a dual banking environment, the monetary authorities can deploy different kinds
of masharakah based contracts to run its open market operation instrument. For example,
Islamic certificates such government musharakah certificates (GMCs) and central bank
musharakah certificates (CMCs) have been effectively used in Malaysia, Saudi Arabia,
Bangladesh, among other countries (Sarker, 2015).

3.7.3. Murabahah (cost-plus financing)

This is one of the most used modes of Islamic financing across Islamic banks. Under this
mode, the Islamic banks purchase products from third parties and sell them to their
customers at the cost of the products plus some mark-up that is mutually agreed upon
between the banks and their respective clients (Hawary et al, 2004; Usmani 2002 and
Thani et al, 2003). The payment can be either immediate or deferred or both (Omar,
2013). Lately, some Islamic economic scholars have criticized this mode on the ground
 77

that it does not only resemble interest-based instruments but that also it allows interest
through the back door (Metwally, 1994). In fact, some scholars argue that murabahah
mode has lost the essence for its existence because of mimicking the interest-based debt
contracts. Therefore, efforts ought to be made to revive this important mode to its shari’
compliant principles.

However, those in favour argue that the extra payment that the client makes is justified
on two grounds; first, it is a payment for the service that the Islamic bank offers in this
type of contract and second, the margin or mark-up is not stipulated in terms of time. In
other words, unlike interest rate payment, the profit margins (mark-up) here do not change
from the agreed upon price due to delays in making payments. Most importantly, the bank
continues to own the asset in question until total payment for it is made. This therefore
implies that the bank bears the risk associated with the transaction until it is settled. So,
this by all standards makes murabahah (cost plus margin) financing an equity-based
principle.

The controversies above notwithstanding, murabahah dominates Islamic banking and

finance institutions as the most employed mode of Islamic finance. As regards monetary
policy management, the central banks employ different asset-based securities
(government investment certificates (GIC)) that are issued against a cross section of
contracts murabahah contracts inclusive (Wajdi, 2010).

3.7.4. Ijarah (Islamic leasing)

This is defined as the sale of the rights to use a commodity or services for a specified
period as the case is in conventional economic system. So, it is a mode of finance in which
Islamic banks purchase and lease out valuable equipment or assets required by customers
for an agreed upon rental fee. Since the ownership of the lease’s asset/equipment remains
with the lessor throughout the contractual period, all the insurance and any maintenance
costs equally remain their responsibility. The most peculiar feature for an ijarah contract
is that the lessor has the right to renegotiate his contractual terms at agreed upon interval
periods. This is intended to ensure fairness such that these terms are aligned to the
prevailing market leasing rates.
 78

In case the lessee intends to buy the leased equipment / asset at the end of the contract
period as the case is in case of diminishing musharakah, he or she is required to inform
the lessor so that they enter a different type of ijarah contract known as ijara wa iqtinah
(Hire-Purchase). The difference between an ordinary ijarah contact and the ijarah wa
iqtinah is that in the latter, the client makes a commitment to purchase the product in
question for a specified price at the time of the contract.

Open market operations based on this form of contract that have employed by different
countries especially OIC member countries include government investment certificates,
central bank investment certificates (CICs). These have actively been employed in
countries such as Malaysia, Bangladesh, Sudan among others (Sarker, 2015).

3.7.5. Wakalah (Agency contract).

This refers to an Islamic contract whereby an investment account holder (muwakkil)

appoints an agent (wakiil) to undertake a clearly defined legal duty or action on his or her
behalf. The realised profits are then distributed in accordance with the pre-agreed upon
profit ratios between the two contracting partners. Similarly, in case of a loss, the two the
agent (financial institution) and the account holder (principal) share the loss as agreed on
the onset of the contract, (Bank Negara Malaysia report, 2015).

As an instrument of monetary policy management, this tool takes largely two forms; that
is: wakalah wa ijarah (agency and leasing) and Wakalah wa Ijarah Muntahia
Bitamlik (agency and leasing-sale). In both cases the monetary authority receives fixed
and predetermined fees from depositors like Islamic banks.

Based on the concept of Ijarah, the monetary authority offers the two Islamic monetary
certificates for the funds from depositors in case of a monetary contraction policy. With
these funds, the central bank then buys leasable asset(s) for them to be leased to the third
party. The third lessee keep receiving an agreed upon rental fee throughout the specified
contractual period (Mirakhor and Iqbal, 2007).

Furthermore, Wakalah is one of the most effective and efficient instruments with which
the monetary authorities regulate the Islamic banks and financial institutions’ liquidity
status, (Al-Bashir and Al-Amine, 2013, p. 132). The central bank may offer Islamic
monetary certificates (IMCs) (Ismal, 2011), letters of credit (LOC) (Maldives Islamic
 79

Bank, 2011), Term Deposits (Ismail et al., 2016), Islamic bonds and insurance services
(Nahar, 2015) among other wakalah contract forms.

3.7.6. Salaam contract (advance purchase)

This relates to a forward sale where the bank pays fully for a specified quality and quantity
of goods that are delivered later (Tabakoğlu, 2008: 305). So, it is an advance payment
mechanism in which goods are fully paid for now and delivered at an agreed upon future
date (Işık, 2010). It is mainly used in agricultural sector financing aimed at helping
farmers to meet the farm expenses during the harvesting period. In other words, it caters
for entrepreneurs whose businesses require funding based on the season. The seasonal
factor exposes the funders (banking institutions) to market risks related to seasonal
commodity price fluctuations (Usmani, 2002).

Salaam contract can either take the form of ordinary salaam which involves two
contractual parties or parallel salaam in which two different and independent contracts
are undertaken. The main essence of the parallel salaam contract is to enable banks and
or investors to hedge against price fluctuations that are associated with seasonal produce.
So, the bank is the buyer in the first contract and the seller in the second one (Isra, 2012).
For example, the bank can pay for the farmers’ goods in the first contract and sellers those
same goods in the second (parallel salaam) contract to the farmers’ cooperatives as the
case is in the case of Muslim Aid Sri Lanka and Wasil Foundation for Sri Lanka and
Pakistan, respectively (Kaleem and Ahmad, 2010; Muneeza et. al., 2011; Obaidullah,
2015). It is an effective mode of litigating losses that are associated with price volatility
through advance contractual agreements.

Salaam as a mode of finance is underpinned by both the Holy Quran and the traditions of
the Prophet (PBH). Allah says:

“Oh ye who believe! when ye deal with each other in transactions involving future
obligations in a fixed period reduce them to writing. Let a scribe write down faithfully as
between the parties: let not the scribe refuse to write as God has taught him so let him
write. Let him who incurs the liability dictate but let him fear his Lord…” (Al Baqarah,
282).
 80

From the traditions of the Prophet (PBH), Ibn Abbas (Allah Be Pleased With him)
narrates that on his arrival to Madinah, the Prophet (PBH) found the inhabitants of the
city involving in salaam (forward) contracts in fruits for one, two, and three years. He
(PBH) then guided on the contract as follows:

“Whoever enters into a forward contract let him specify a known volume or weight, and
a known term of deferment” (Al-Bukhari, 2126).

Central banks deploy different salaam-based certificates to manage monetary policy.

Such certificates as government investment certificates and central bank ijarah
certificates are good examples under this mode of finance.

3.7.7. Istisna’a

This is defined as a contract of exchange in which goods are paid for to be produced in
future. This type of financing is particularly suitable in the manufacturing industry where
specifications are made, and the financing is progressively made as the construction work
progresses. For example, if a client approaches his bank with a need to finance a house
construction, the bank engages the contractor to build the specified house for its customer.
The bank funds the project and upon its completion, the bank enters into a separate sale
agreement with the customer based on any of the earlier mentioned finance modes such
as murabahah, diminishing musharakah extra (Omar, 2013; Hawary et al, 2004).

Under this mode, customers can obtain their long-term large-scale financing that would
otherwise remain unfunded. The repayment schedule is agreed upon between the parties
in the contract and can be a lumpsum or through instalment (Iqbal and Llewellyn, 2002).
It is in a way related to a murabahah contract. However, in this case, the goods are paid
for before they are actually produced in the conventional economic theory, istisna’ can
be related a futures market in which an entrepreneur sells his products to the customers
at a pre-determined price.

In its Islamic open market operations, the central bank may employ certificates that are
contracted on istina’ basis. Government istisna’ certificates, central bank istisna’
certificates, among others.
 81

3.7.8. Sukuk (participation securities)

Sukuk is an Arabic word which literally means certificates. It is the closest resemblance
to the conventional bonds (Sevil, 2013; Schoon, 2016). It can therefore be translated to
mean “Islamic bonds”. Some scholars have translated it to mean “Islamic Investment
Certificates” (Tahmoures, 2013)33. It is the newest and notably the most outstanding
Islamic tool that has gained quick acceptance across countries as a very effective and
important tool not only for funding huge projects such as government expenditures but
also as an instrument liquidity regulation.

From the Islamic economic and financial perspective, it is defined as certificates that
represent a proportion of undivided right of ownership in a business venture, pool of
tangible property or properties that are sharia compliant. This ownership right implies
that the person is entitled to a financial right to the receipt of revenues generated by or
from the underlying sharia compliant tangible asset through a special purpose vehicle
(SPV) (Jobst, 2007). Below is a generic structure of sukuk.

33
According to the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI),
Sukuk refers to certificates of equal value representing undivided shares in ownership of tangible assets,
usufruct, and services (El-Mosaid and Butti, 2014).
 82

Figure 3.4. A generic structure of sukuk

Corporation Sharia
3. invest compliant
investment
4.Returns

1a. Sell
asset
2b. Transfer
funds

6. Sell
asset
7. Payments

Sukuk
1b. Sell sukuk certificates
Holders /
Investors 2a. Payments SPV

5. Coupon
4. Returns
6.Sell asset
7. Payment

Source: Schoon (2016).

Unlike the earlier defined instruments, sukuk is not a separate tool but rather a structure
that facilitates financing to large projects that are otherwise difficult or impossible for
individual investors. It is thus undertaken based on the instruments mentioned earlier.
Several Muslim majority countries have been issuing sukuk. Since mid-2000s, sukuk has
been growing at an unprecedented speed and quickly gaining acceptance in the
conventionally dominated western economies.

Countries like Bahrain, Sudan, Iran, and Malaysia among others use different kinds of
sukuk to aid Islamic banks to manage their liquidity challenges. Examples of such sukuk
as ijarah sukuk (Rımaz, 2014, p. 55; Tok, 2009, p. 20), musharakah sukuk (Usmani, 1998,
p. 39) and Sukuk Al-salam (Tunç, 2010, p. 151; Usmani, 1998, p. 130), mudarabah sukuk
(Büyükakın & Önyılmaz, 2012, p. 4) among other kinds. Since its first issuance in the
early 2000, the global sukuk issuance has been growing with its peak in 2012 as illustrated
in the following figure:
 83

Figure 3.5. Total global sukuk issuances (Jan 2001 - Dec 2017) all tenors, all
Currencies, in USD Millions

Source: IIFM sukuk report 2018.

As can be seen from the figure above, the total global issuance grew relatively steadily,
reaching maximum in 2012. It then declined for three be resuming the growth pattern
again. By 2017, it amounted to USD 116.7 billion. The increase from USD 87.9 billion
in 2016 to USD 116.7 billion in 2017 demonstrated an impressive jump of around 32%
in volume. This increase in volume during 2017 has been attributed to sovereign Sukuk
issuances by Saudi Arabia coupled with steady issuances from Asia, GCC, Africa and
certain other jurisdictions while Malaysia continue to dominate the Sukuk market though
share of countries like Indonesia, UAE and to some extent from Turkey increased as well.

The principles of Islamic finance and the instruments of Islamic monetary policy as stated
above work in a synchronized way to facilitate the realization of macroeconomic goals.
For example, the profit and loss sharing instrument, asset-backed obligation, the “zakat
system” coupled with the strict prohibition of usury accelerates investment activities to
the real sector. The improved production in the real sector creates more job opportunities,
fair income distribution, increased aggregate demand, economic growth and ultimately
improved social welfare. The general picture of the impact of these principles and
instruments are summarized by Meera (2004) as follows:
 84

Figure 3.6. The general impact of interest-free based financial and monetary policy

Islamic
banking

Islamic
Monetary Islamic Financial Output
policy money Services Inflation
market Industry

Islamic
capital market

Islamic
monetary Wealth Real Sustainable
sector Increased
system (Profit and Production stable
and loss growth inflation
income and higher
sharing, qard and rate of Job rates, econ
redistribu
hassan, zakat expansion opportunities growth and
tion Development
system)

Source: Saiti (2016), and Sakti (2007). Green colour implies fully operationalized; Grey
colour indicates still at embryonic stage.

As shown above, the figure above contains two sections. The upper section of the figure
demonstrates how the conventional monetary policy shocks affect the nascent Islamic
finance industry and impedes its full potential towards the realisation of sustainable price
stability and economic growth. Due to the dominance of the conventional economic
system with high percentage of floating customers34 compared to the faithful35 ones across
these countries, a monetary policy shock affects the deposits of Islamic banks and the
Islamic capital markets simultaneously as indicated by the arrows (Çevik and Charap,
2011).

34
Floating customers relate to those bank clients whose investment decisions are based on the rate of return
on their money. They no consideration the shari’ compliancy principles. They are only sensitive to
fluctuations in the rate of interest.
35
Faithful customers are those whose investment decisions are influenced by the Islamic economic
teachings considerations as opposed to the rate of returns from their investment ventures.
 85

The reduction in demand and investment deposits affect the money market which is the
main component through which monetary policy is executed (Yungucu & Saiti, 2016).
The effect is a constraint on the Islamic finance services industry and hence difficulty in
achieving monetary policy goals (Sufian, 2007). This makes the implementation of
monetary policy through the Islamic banks very challenging when the industry is not big
enough to match its conventional counterpart in a dual economic environment as the case
is across these countries (Khatat, 2016).

The lower section on the other hand demonstrates the potential impact of monetary policy
management through the shari’ compliant instrument. From this section, the Islamic
financial and monetary system facilitates the efficient and effective achievement of the
macroeconomic goals that all monetary authorities are tasked to pursue. So, the economic
condition and standings of the Muslim majority countries practicing Islamic banking and
finance do not exhibit the performance showed in the above figure. This is attributed to
the dominance of the conventional monetary practices amongst these economies and the
nascent state of Islamic money and capital markets (shaded grey in the figure) as well as
the lack of full political will and support for the Islamic monetary policy implementation
(Chapra, 2000).

However, there have been some recent development in the industry that are aimed at
regulating liquidity among Islamic banks of the OIC members. For example, monetary
authorities are steadily beginning to employ the above tools as demonstrated in the cross-
country comparisons of Islamic monetary policy implementations in the following figure.
 86

Figure 3.7. Showing cross-country comparisons of mechanisms for short-term liquidity

regulation amongst Islamic banks

Interbank Short- CBPC

Government
Commodity Murabahah Government Investment term /Wadiah
Musharakah
Murabahah investment certificates Salam- certificate
certificates
sukuk
Islamic Mudarabah Ijarah or Wadiah
Murabahah Musharakah Salam
mode Murabahah and Jualah
Bahrain Bangladesh Sudan Sudan and
Country Indonesia Bahrain Indonesia
S.Arabia Iran Malaysia
of use Malaysia
Malaysia
Underlying Government Government A share
assets to Commodity, Central financing in Gov.
equity inn
which Metal banks’ contract to Commodity dev.
some
returns are assets finance projects
commercial
linked banks public exp.
3-month paper
Range of Up to 12 Up to From 2 rolling program
2 years
maturitie Months 12 years of monthly
s issuance.

No Not easily Freely Potentially Not Tradable

Tradability
tradable tradable tradable readily only at par
tradable
Suitability Very Recently
Not Not well
for expensive to introduced Not
flexible suited for Not well
monetary conduct to replace suitable
for monetary suited to
operation monetary GMCs for
monetary operations absorb
policy or to gradually monetary
i liquidity
finance gov. and appears operations
expenditure promising.

Source: Sarkar (2015, p. 25).

As can be evidenced from the above figure, many of the tools are still in their infant stages
and thus not developed well to absorb and inject liquidity into the economy. Yet like their
conventional counterparts, Islamic banks are required to meet the liquidity coverage ratio
(LCR) by increasing the amount of high-quality liquid assets (HQLAs) in their portfolios.
Therefore, given the nascent and shallow state of Islamic security markets, coupled with
the short supply of sharia compliant HQLAs, many Muslim countries simply duplicate
the conventional tools, Basel Committee on banking supervision report (2013). This
necessitates an analysis of the practices of these countries to understand how they transmit
their monetary policies.
 87

3.8. The contemporary financial and monetary practices of Muslim countries

The rapid growth and development of the Islamic banking and financial system has not
been without contempt. Over the years, there has been an overwhelming influence of the
conventional economic system over the Islamic based one. The long period perceived
economic prosperity that capitalist economies have achieved has seen Islamic economic
scholars not only intellectually inclined towards the conventional theories and practices
but also utterly doubtful about the Islamic economic system’s ability to offer any genuine
alternatives on the economic dilemmas that the global economy grapples with today
(Ascarya, 2007).

The design and development of products that are` Islamic in form but conventional in
substance alludes to this claim. Below is a brief look at the financial and monetary
systems of these countries and subsequently a comparison is made on their system with
the actual teachings of an Islamic monetary system.

3.8.1. Islamic banking, finance, and monetary policy practices of the selected
countries

Saudi Arabia: This is an oil-based economy which is the largest in Middle East. Saudi
Arabia possesses the largest banking sector in the Middle East with a total of 23 licensed
banks, 12 of which are government incorporated. As an oil-based economy, fiscal policy
assumes dominant role in the management of economic activities. Ironically, much as the
country is governed as an absolute monarchy with the government claiming Islamic
religious authority, her monetary policy authority institution was established through a
Royal Decree of 1952 like the conventional banking laws. The principal objective of
monetary policy has remained one of maintaining price and exchange rate stability.

As a fixed exchange rate regime, her monetary policy is mainly influenced by monetary
developments in the anchor country (United States of America). However, Saudi Arabia
monetary authority (SAMA) employs three main instruments in monetary policy
management operations: policy interest rate corridor, open market operations through
issuance of SAMA bills, and statutory reserve requirements. These are mainly transmitted
through the bank credit channel. It also employs macro-prudential instruments that
enhance monetary and financial stability (Hossain, 2015).
 88

Although it constitutes the largest share of Islamic asset shares, Islamic banking and
finance practices began much later than other Muslim majority countries and in a more
complicated way.

To this day the Islamic banking industry of Saudi Arabia is remain relatively small. There
are only four banking institutions, namely Al-Bilad, Al-Inma, AlJazira Bank, and Al-
Rajhi, offering banking and investment services according to Islamic teachings (Hassan
et al., 2018). Despite the late implementation and the small number of Islamic finance
services in the country, Islamic banking and finance assets shares surpassed half of the
national market (51.2%) and the prospects for expansion continue to grow at a record
speed.

Malaysia: The financial system of Malaysia has been undergoing faster growth as well
as major structural transformation since the 1960s. The banking industry dominates the
economy with as many as 25 commercial banks and 18 Islamic banks. Enjoying a good
political will from the government, Islamic banking and finance has flourished in
Malaysia’s diversified financial system. So, apart from the 18 Islamic banks, there also
more than nine takaful operators, more than 100 Islamic products offered among other
services.

Unlike many of the Muslim majority countries, the history of Islamic banking and finance
in Malaysia began as early as 1963 with the establishment of the Malaysian Pilgrims Fund
Board (Tabung). By 1983, the first full-fledged Islamic bank known as Bank Islam
Malaysia Berhad was established. This was followed by Bank Mu’amalat Malaysia
Berhad (1999). Between 2000 and 2016, the industry drastically increased to 16 full-
fledged Islamic banks operating in Malaysia. This accelerated Malaysia to the leading
Islamic banking and finance International hub especially in the South East Asia (Monthly
statistical bulletin, (Bank Negara Malaysia, Dec. 2017). Malaysia is the leading Muslim
majority country in Islamic capital market development especially sukuk.

As regards monetary policy, the central bank of Malaysia (Bank Negara Malaysia) is
charged with the duty to manage the country’s economy. Its prime objective and goal are
to achieve sustainable monetary and financial stability. To achieve those goals, several
instruments including open market operations, discount window, reserve requirements,
 89

and moral suasion that are employed. Monetary policy transmission mechanisms used
include interest rate channel, exchange rate channel, and asset price channel.

Kuwait: In Kuwaiti, the phenomenon of Islamic banking and finance was born with the
establishment of Kuwait Finance House (KFH) (1977), Owing to its heavily endowed
natural mineral resources like Petroleum, it quickly evolved to become the Muslim
majority country with the largest number of Islamic banking and finance institutions. In
early 2000, it was ranked the third country in terms of holding the Islamic Finance Assets
in the World (Khojah, 2006).

The principal objective of Kuwait Central Bank is to achieve and maintain price stability
and financial stability. Like Saudi Arabia, the national currency of Kuwait (Kuwait Dinar)
is pegged to the US Dollar. Therefore, much of the monetary developments of the country
are anchored from the changes in the federal reserve rate. Although, however, the Central
Bank of Kuwait can exercise some flexibility in setting its own policy rate at some level
while maintaining a close alignment to the Us Dollar interest rate. This helps the monetary
authority to achieve a positive interest rate differential in favour of the Kuwait Dinar
(CBK report, 2017).

To achieve its monetary policy objectives and goals, the central bank employs both
monetary and macroprudential instruments which include, discount rate (official policy
rate), open market operations, conventional direct investment and tawaruq, among others.
The monetary policy stance has been maintained to be supportive of conditions that
reconcile aggregate demand with price stability.

Qatar: The financial system of Qatar has been growing rapidly since 1971. Islamic
banking and finance began taking shape in Qatar in 1982 with the establishment of Qatar
Islamic bank which officially commenced its operations in 1983. By 2014, it was ranked
sixth in the Islamic finance Worldwide (Reuters, 2014).

The monetary policy is managed by Qatar Central Bank and pursues sustainable price
stability as its main objective and goal. The tool used include among others open market
operations, Discount rate, reserve requirement, moral suasion, and liquidity ceiling.
However, this is exercised with constraint as the country pegged her currency on the US
Dollar. So, much of the monetary developments are determined by the developments in
the monetary changes in the anchor country.
 90

Turkey: Much as Turkey has a population of nearly 100% Muslims, Islamic banking and
finance did not take shape until 1983 when the need to attract big capital investments
from the Middle East became eminent (Alpay, 2007). Since then, Islamic banks and
financial institutions grew rapidly particularly after the ruling AK Party (Justice and
Development Party) took charge of government. By July 2015, there were a total of 4
fully fledged Islamic banks with several branches across the country. The Turkish Central
Bank Report (2017) evaluation put the total asset value of Islamic banks and financial
institutions at 5.1% of the total GDP of the country.

Having started in 1932, the Central Bank of the Republic of Turkey began its operations
as a joint stock company with the authority to issue bank notes as a legal tender. With the
advent of Turkish economic development plans in the 1960s, several changes were made
in the central banking law. Like the other countries, the main objectives of monetary
policy are to achieve sustainable price and financial stability (Erdem et al., 2017; Gülçin,
2019).

The monetary policy transmission mechanisms in Turkey include interest rate channel,
exchange rate channel, asset price channel, credit channel and expectations channel
(Duman, 2016; Özekicioğlu, 2013; Özatay, 2011).

Indonesia: Although the idea of Islamic / shari-based banking were conceived as early
as the 1930s, for various reasons, there was not any Islamic bank established in Indonesia
until 1992. Between1992-2000, visible trends had been registered as far as Islamic
banking and finance is concerned. For example, according to the Islamic bank statistics
of Bank Indonesia 2003-2016, as of July 2016, there were up to 12 shari’ banks, 22
Islamic windows in the conventional banks, 58 Takaful operator, 163 sharia peoples
credit banks otherwise known as rural Islamic lenders, and about 5500 rural cooperatives,
7 Islamic finance-based investment firms among other Islamic financial services. Much
as these services only make up to 5.3% of the national asset share of the Indonesian
economy, it forms the highest number of sharia compliant institutions any country has in
the world. This qualifies Indonesia on the list of the leading Muslim-majority countries
(86% Muslim population) in Islamic banking and finance implementation (Ernst and
Young, 2015).
 91

The sole objective and goal for monetary policy management by Bank Indonesia is to
achieve sustainable price and exchange rate stability with much emphasis put on the
former (Alamsyah et al., 2001; Subandi, 2014; Pohan, 2008). The monetary policy tools
employed to achieve its goals include discount window, open market operations,
minimum reserve requirement, and selective credit control (Manurung, 2008; Budiono,
2001).

Bahrain: Islamic banking in Bahrain commenced in 1979 with the establishment of

Bahrain Islamic bank. Many sharia-compliant institutions joined in the following decade
whereby her status rapidly grew to become the financial centre among the GCC countries.
By 2001, short-term Al-salam Sukuk and long-term Ijarah Sukuk among other tools had
already been introduced to this Gulf country to facilitate monetary policy operations and
further investment opportunities for the Islamic banks (Basu et al., 2018). As of July 2015,
out of the 27 banks in Bahrain, 24 operate strictly on Islamic basis. Bahrain is thus
considered to be at the forefront of the international Islamic financial services Industry
and therefore home to the AAOIFI since the 1990s.

The central bank of Bahrain aims at achieving price and financial stability as its prime
objective and goal just like the other countries explained above. To achieve those twin
objectives, the Bahrain pegged (fixed) her currency on the US Dollar. The central bank
also employs some tools including open market operations, reserve requirement, discount
rate, among others. The main transmission mechanism employed include interest rate
channel, credit channel and exchange rate channels.

Pakistan: Islamic banking and finance efforts in Pakistan dates bank to 1979 when the
first Islamic bank was established there. The Islamization of banking and financial
operations took a drastic turn during the 1980s as financial authorities attempted to
eliminate interest rate charges in the entire banking industry. The industry grew
tremendously over the two subsequent decades across Pakistan. By the second quarter of
2018, the share of full-fledged Islamic banks and banking branches of conventional in
overall assets of the Islamic banking industry clicked a record level of 58.5% and 41.5%
respectively (Islamic banking bulletin: April-June 2018).

The contemporary monetary practices of Muslim majority countries are more

conventional in nature than Islamic. One reason for this could be because they are
 92

dominated by the conventional commercial banks with international and national market
shares accounting for over 70% assets in every country apart from Saudi Arabia and
Kuwait. The global and national share of the Islamic banking assets for the above core
markets for the Islamic finance stood as follows by 2016. We emphasize Islamic banks
because they dominate the Islamic finance industry (Hassan & Aliyu, 2018).

Figure 3.8. Showing both the international and national share of Islamic banking and
finance assets for the nine core markets

Source: World Islamic Banking Competitiveness Report 2016.

Apart from Saudi Arabia and Kuwait, the share of Islamic banking and finance assets
constitute a very small percentage on both the international and national scale for each of
those countries. This dominance tends to influence the Islamic banking and finance
institutions to tend to resemble their conventional counterparts. For example, Çevik and
Chapra (2011) study found co-integration, causality, and volatility correlation between
conventional and retail Islamic banks deposit returns in Malaysia and Turkey. The
operational concepts of the true Islamic monetary system, the contemporary practices,
and their conventional counterparts.

Under a fully Islamised economic environment, the monetary system of the two systems
would be characterised differently as shown in the following table.
 93

Table 3.3. Characteristics of Islamic and the conventional monetary systems

No. Islamic monetary system Conventional monetary system
1. Fully backed money / fully bodied Fiat money
2. 100% reserve banking system Fractional reserve banking system
3. Profit and loss sharing (risk sharing) Interest rate-based system

From the table 3.2, the Islamic and conventional monetary systems are fundamentally
different (Ascarya, 2006). These three distinct features form the basis for money creation
in the conventional sense, which in turn influences the inflation rate in an economy.

On the fully backed money / fully bodied money versus fiat money36, the fully bodied and
or fully backed money feature implies that money is either in the form of precious items
such as gold and silver which possess intrinsic value equivalent to their nominal value or
in the form of paper and coins whose nominal values are fully backed by gold and silver
equivalent as stored by the monetary authorities who issue it. This feature eliminates
seigniorage revenue generation tendencies that erode the value of money whenever new
purchasing power is created. Therefore, the critical role of money as a store of value is
maintained under the Islamic system (Hassan, 2002). Most importantly, there is relative
stability in the price level since the money is issued based on the real sector needs, that is
there is no dichotomy as assumed by the classical economic theory.

On the contrary, the issuance of fiat money by the government through the central bank
as practiced in the conventional enables it to generate seigniorage and create new
purchasing power. However, this erodes the value of the currency equivalent to the
amount of the new money created (Fischer, Sahay and Vegh, 2002; Bresciani-Turroni,
1937; Cagan, 1956). So, this accelerates inflation tendencies in the economy and thus
subjects the poor cohort section of the population to undue suffering especially if it
reaches hyperinflation levels (Romer, 1990). Seigniorage may be considered as riba since
it is created without a counter value, risk and or any value added (Ascarya, 2006). In other
words, it creates benefit to one party without counter value to the other party.

On the reserve requirement feature, the two systems differ quite significantly. Under the
Islamic system (100%) reserve requirement, the deposited money must be deposited to

36
Fiat money relates to paper and coin money that is accepted as a legal tender without being backed up
by valuable items such as gold and silver.
 94

the monetary authorities as received from the customers. There is a two-window model
that is being encouraged for the stability of the Islamic financial and monetary system.
That is, the demand deposits being backed-up by 100% reserves and the investment
deposits being accepted based on risk sharing between the fund’s owner and the
entrepreneur (Iqbal, 2016). This ensures that inflationary tendencies are minimised since
no new purchasing power is created (no seigniorage revenues). In other words, the Islamic
banks and or any financial institutions in this arrangement can offer loans as much as the
original deposits received and thus ensure relative stability in the financial system (Al-
Jarhi, 2015; Ergeç et al. 2014).

On the other hand, the fraction reserve requirement in the conventional system allows
commercial banks to create new deposits. This is because, they are required to hold
reserves that may range between (5% - 20%) of the mobilised deposits. So, the bank can
create fiat money in form of demand deposits and or electronic money as it extends
multiple loans to different customers from a single deposit mobilised (Meera, 2012;
Smith, 2010). The creation of new deposits without regard to the level of economic
activities erodes the aggregate purchasing power of the money (that is, it facilitates
inflation tendencies) equivalent to the number of deposits created in the monetary sector.
So, commercial banks can generate profits from lending money. This is considered illicit
earning as it contravenes the Islamic ethical and moral basis for a descent income whereby
production and exchange of good and services forms the main principle for income and
wealth creation under the Islamic economic order (Erdem, 2017).

The last feature (interest versus profit and loss sharing). This is the most fundamental
feature that differentiates between the Islamic and the conventional monetary system. The
principle of fairness is fundamental for the validation of any financial dealings under the
Islamic economic order. In fact, the ban on interest charges is because it is categorised as
an unfair treatment and oppression of the poor by the wealthier (Ahmad, 2003, p. 454).
Secondly, for the contract to be valid, the terms of profit earnings from a prospective
business venture cannot and should not with certainty be fixed as an income before it is
subjected to risk (Erdem, 2017). Besides the theory of Islamic rate of returns stipulates
that taking a profit from a product remains illegal if it does not contain the three
elements (i) the value addition element in a product because of work (kasb), (2) risk
 95

taking (ghurm) due to price changes during the trade period and lastly (iii) writing down
the liability in case there is a defect in goods sold (dhaman) (Rosly, 2005).

Therefore, while the conventional system perpetrates unfairness, oppression, income

inequality and other forms of zulm (Exploitation) through the institution of interest rate,
the Islamic economic system seeks to guarantee an economic order that is based on,
equity, fairness and no zulm (exploitation). So, interest is banned completely as
mentioned in the Holy Quran in various verses including (Quran, 3:130-132, 2:276-281)
among other verses and in the different traditions of Prophet Muhammad Peace Be upon
Him (PBH).

An alternative economic order known as risk sharing or profit and loss sharing that ensure
all parties in the contract are dealt with fairly and justly is undertaken. Most importantly,
interest rate charging breeds speculative tendencies in the economy thereby accelerating
inefficiencies and instabilities in the operations of any economy, regardless of whether it
is the conventional or otherwise. This alternative system is considered relatively more
stable as compared to the conventional system as minimises speculative behaviours that
accelerate inefficiencies (Kasaroğlu, 2015). As mentioned earlier, all the major economic
crises in the past have in one way or another been blamed on interest rate charges that
breed speculative tendencies (Ahmad, 1994).

However, despite those distinct characteristics, the Muslim majority countries have not
yet been able to practice them as explained. Instead, they practice them as a mixed system
with more inclination towards the conventional system as illustrated in the following
table. Their practices in fact mirror the conventional system in many ways as confirmed
by various studies (Shawtari et al., 2015; HanimTafri et al., 2011; Azhar, Rosly and Zaini,
2008; and Sufian, 2007).

Table 3.4. Comparison of the characteristics of the Islamic monetary system,

conventional system, and the practices of contemporary Muslim majority countries
NO. The Islamic monetary Contemporary Muslim Conventional monetary
concept. majority country systems. system.
1. Islamic money as earlier Fiat money (paper money) Fiat money (Paper
defined (asset backed) money).
2. 100% reserve requirement. Fractional reserve requirement Fractional reserve
requirement.
3. Profit, and loss sharing Profit and loss sharing. Interest rate
(Rrsk sharing).
Source: (Ascarya, 2007).
 96

From the above table, apart from the profit and loss sharing property whose ratios are
even benchmarked on the interest rates or the policy rates as announced by the monetary
authorities, contemporary Muslim majority countries are simply replicating the existing
capitalistic monetary system. Instead of the 100% reserve requirement that would ensure
that inflationary tendencies are kept in check, monetary authorities in these countries
employ fractional reserve system which enables them to create new money (demand
deposits and electronic moneys) and earn seigniorage. Instead of using fully bodied
money that is fully backed by precious items such as gold and silver, they employ fiat
money. This partially explains why they continue to face high unemployment rates and
low GDP levels despite increased percentage of Islamic banking and finance.

This mixed practice of financial system management without strict adherence to the
norms of Islamic precepts is weakening the very essence of Islamic banking and finance
intendeed by the shari’. According to Rosly (2005), the path of development of the
Islamic finance industry seems to be aimed at mirroring its conventional counterpart as
illustrated in the following figure.

3.8.2. An illustration of the contemporary Islamic finance system as practiced in

Muslim majority countries

As seen from the above characteristics that differentiate the two financial systems, it
would be expected that each develops distinctively from each other. However, the
practices of the contemporary Muslim majority countries seem to be replicating
(imitating) the conventional system instead (Askari et al., 2012; Faisal, 2016). In other
words, the full domination of the capitalist conventional financial system as shown earlier
influences the Islamic financial institutions and hence limits their ability to perform fully
(kaffah) as per the shari’ expectations. For example, participation banks in Turkey have
been criticised for inclining towards conventional related modes of financing. They for
instance mobilises deposits on the madarabah basis but largely prefer providing funding
for projects on a murabahah basis (Aras and Öztürk 2011).

Several institutions are active in the Islamic sector including commercial banks, finance
companies, merchants’ banks, takaful companies, securities firms, unit trusts, savings
institutions, rural cooperative banks, Islamic money market and Islamic capital market.
 97

But participation banks are the most effective structures and institutions of this sector
(Bulut, 2012).

Figure 3.9.An illustration of the contemporary Islamic financial system as practiced in

Muslim majority countries

Islamic Financial system

Surplus Islamic Financial Deficit

sector Market sector

Islamic
Direct Financial Indirect financial insurance
Islamic money
market market
market
Islamic
unit trusts
Islamic
Islamic capital commercial
market and investment
banks Islamic
Fin
Company

Islamic bond Islamic equity

market market

Source: (Rosly, 2005).

Whether Islamic or otherwise, a financial system comprises covers five aspects including,
i) money markets, ii) policy and legal aspects; iii) financial support; iv) financial
institutions; and v) financial agents. The Islamic financial services industry continues to
grow at record level in both dual and single economies. Most importantly, it has gained
very high momentum as regards market share since early 2000s especially in sukuk and
securitisation (El-Qorchi, 2005, p. 47). Without a good financial system, the monetary
policy objective of achieving a sustainable price stability can hardly be realised.
Therefore, the Islamic financial system which is built on strong ethical and moral
principles of honest in business dealings, prohibition of riba and gharar as well as maisir
 98

is the ideal system for system economic growth and social-economic justice of any
economy (Obaidullah, 2005; Ascarya, 2009).

From the above figure, like the conventional system, the Islamic financial system plays
the same role of intermediation between surplus spending units (fund owners) and the
deficit spending units (entrepreneurs). So, the saving-surplus economic agents or
wealthier individuals inject their money into the financial markets where the saving-
deficit spending ones can access them through the Islamic finance modes based on profit
and loss sharing arrangements. The arrows indicate the movement of investment funds.

The financial system therefore provides the economy with funds through an array of
financial products and services. While some of the products are direct financial including
the Islamic capital markets, Islamic bond markets and the Islamic equity markets, most
of the products fall under the indirect financial market categorisation. These include
Islamic commercial and investment banks, Islamic insurance, Islamic unit trusts, and the
Islamic finance company. For the Islamic money market, it stands between the indirect,
the direct financial markets and the Islamic financial market (Djebbar, 2012).

The conventional and the Islamic finance systems are operationally different in that the
former is monetary-based while the latter is a real sector activity (asset) -based system.
The countries that are adopting the Islamic banking and finance operations have had to
maintain this classical theory dichotomy in their structural set up Ascarya (2007) as
illustrated in the figure below.
 99

Figure 3.10. The Contemporary Monetary System structure in Muslim Countries

Ms, i,Tx, Sb Zk, Inf, Sd, wq

Monetary and financial Social institutions

authority

IFIs

Money Real
Market Market Households

Firms

Monetary
Real sector
sector

Ms: Money supply; i: Interest rate; Tx: Tax; Sb: subsidy; Zk: zakat; Inf: infaq;
Sd:shadaqah; Wq: Waqf; IFIs: Islamic Financial Institutions. Dotted line running from
money market to Real market demonstrates a missing link the two sectors under the
conventional arrangement.
Source: Adopted from Ascarya (2007).

From the figure (3.9) above, the Islamic sector is in principle supposed to deal with the
entire economy. However, to the dual nature of the economies under study, monetary
authorities have had to maintain the classical dichotomy kind of economies. Owing to its
asset backed obligation, the Islamic financial system focuses largely on the real sector.
All economic agents meet in the real market where the prices are determined by the free
market forces of demand and supply. Households receive wages from firms and out of
their incomes, the contribute to the social economic wellbeing of the disadvantaged
members of society through both obligatory payments like zakat as well as voluntary
contributions such as waqf, infaq, Sadaqat among other.
 100

For the monetary sector, firms invest in money markets for example through buying
shares and stocks, deposit money to Islamic financial institutions. Financial institutions
also invest in money markets. The government influences the monetary sector through
regulating money supply, nominal interest rates, taxes, and subsidies for both the
industrial and agricultural sectors. As indicated by the dotted line running from the money
market direct to the real sector, activities in the monetary market have a bearing on the
real sector both in the short and the long run periods.

However, to be useful and effective, the Islamic financial and banking sector ought to
have developed well to enable the monetary authorities especially the central bank to
target the profit-sharing ratios of the Islamic financial tools such as the mudarabah,
musharakah, wakalah extra. This explains why the countries that are implementing
Islamic finance and banking maintain a dual financial system. In this case, the central
bank should develop and implement monetary policies considering the principles of each
system to avoid the temptation of dissolving one system into the other as the
contemporary practices seem to implicate. Below is a sketch of dual monetary policy
transmission mechanism which such central banks should adopt and implement.
 101

Figure 3.11. Monetary policy transmission mechanisms under a dual economy

Central Bank

Exchange Conventional Conventional Islamic Islamic Expectations

rate banks interbank banks’ banks’
reserves rates interbank reserves
funding costs

Conventional Conventional Islamic banks Islamic

bank credit market rates & return on banks
Banks’ lending credit/financing credit/finan
rate cing

Asset prices

Inflation-output

Source: Based on Husin, 2013.

From figure (3.10) above, it is clearly demonstrated that although the contemporary
central banks in dual financial environments may purse monetary policy differently
considering the different operational concepts of the two systems, the end goal is one,
achieving sustainable low level of inflation (price stability) and sustainable high level of
economic growth (output). However, the rates in either financial systems influence each
other with the dominant system (conventional banking sector) playing the biggest role.
Like mentioned earlier on, monetary policy practices in the Muslim majority countries is
more conventional in nature than Islamic. So, until it develops fully, the actual essence
intended by shari’ may remain on paper but not in practice.
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Table 3.5. Summary of the major differences between convention and the Islamic
monetary systems
Item Conventional monetary Islamic monetary policy
policy
Definition The activities of the central Central bank guiding principles on money supply,
bank in monitoring money business transactions (mu’amalat) plus the activities of
supply and inflation through the Islamic banks based on non-interest payment and
adjusting the interest rates. profit-loss sharing.

Origin Capitalism Quran and Hadith

Philosophy To maximize wealth of the Wealth belongs to God, and human beings are
shareholders vicegerent of God to manage wealth in a fair, just and
ethical way.
Objectives Price stability, financial Price stability, financial stability, full employment, and
stability, full employment, optimum rate of economic growth plus elimination of
and optimum rate of riba (usury), gharar (doubt) and maisir (gambling and
economic growth. speculation); socioeconomic justice and ensuring that
there is equitable distribution of income in the
society.
Instruments Open market operation Modified reserve requirement
Reserve requirement Reserve requirement
Credit ceilings Credit ceilings.
Selective credit control Selective credit control.
Moral suasion Moral suasion.
Shariah Not required Strictly required.
Compliance
Source: Mulkiaman, Mohammed, Zakkariya (2016).

3.9. Conclusion

In a nutshell, although there are a lot of similarities between the two systems as seen
above, there are equally some fundamental differences between the conventional and the
Islamic monetary policy that deserve mention as summarised in the last table above. With
the above conceptualisation concerning the points of similarities and differences between
the two financial and monetary systems, the next chapters examines some of the related
works that have taken place in this field with a view to identifying the gaps that justify
the need for this and even further research in the discipline.
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CHAPTER FOUR

REVIEW OF THE LITERATURE

4.1. Introduction

There is a growing literature covering all aspects of monetary policy conduct especially
from the theoretical perspectives related to a dual banking system which is predominant
across the Muslim countries. Some of the theoretical and empirical works on this topic
cover the area of the impact and assessment of monetary policy during crisis (bin Ibrahim
2010; Elekdag et al. 2012; Cheong, 2004; Raghavan et al., 2010; Raghavan et al., 2012;
Doraisami, 2011) and the efficiency, evolution, frameworks, role, and development of
monetary transmission mechanism (Husin, 2013; Kuang and Kuang, 2005; Sukmana &
Kassim, 2010; Hsing, 2014; Majid and Hasin, 2014; Asbeig and Kassim, 2014).

Most Muslim majority countries introduced Islamic finance and banking practices in an
environment characterized with high volatility in inflation. However, their monetary
authorities did not follow up the necessary rule-based monetary and fiscal policies
essential to conform their commitment to maintaining price stability. Many of these
countries are using monetary policy for example to pursue multiple objectives. Yet lately,
in modern central banking operations, both theory and empirical evidence support the
view that price stability is the sole objective of the monetary policy for modern central
banks (Erdem et al., 2017; Hossain, 2009). Most importantly, the stability of the money
demand function forms the core in formulating and implementing a successful monetary
policy (Uddin, 2016). However, not much attention has been paid to it in relation to the
implementation of the Islamic monetary policy.

The literature review in this study the theoretical propositions on the superiority of the
Islamic monetary policy, the weaknesses inherent in the conventional monetary system,
 104

and then empirical studies (both Islamic and conventional) especially those examining
the money demand function co-integration and stability.

4.2. Theoretical propositions

A flow-of-funds matrix for an Islamic economy where the central bank provides equity-
based support to banks is proposed under the Islamic monetary policy framework (Khan
and Mirakhor, 1987). However, their analytical model like many others with conventional
economics background rested on the conventional interest rate variable relabelled as an a
priori variable rate of return. It is, thus, not surprising that they did not find any major
difference in the effect of monetary policy in an Islamic versus the conventional economic
system. In their subsequent seminar paper, they highlighted the importance of mudarabah
mode of deposit mobilization. They also list financing instruments that might be available
in the Islamic financial system. They point out that apart from the Islamic banking system
there would also be primary, secondary and money markets (Khan and Mirakhor, 1994).

Hossain (2009). Stresses that contrary to the conventional system in which the role of
money as an instrument of monetary policy stance is undermined, money plays a very
important role in the Islamic monetary system. Similarly, according to Chapra (1985), the
absence of interest rate, and the existence of some social institutions like Zakat, infaq,
waqf, qardh hassan among others in the Islamic economic system would minimize the
speculative demand for money and lead to a sustainable price stability under a stable
money demand function (MDF) in the economy. He further stresses that the monetary
aggregate instruments play the main role for executing monetary policy in Islamic
economics.

According to Siddiqi (2008), monetary policy is one of the most important subsets of
Islamic economics. The goal of the Islamic monetary policy is to achieve the socio-
economic justice and a fair distribution of wealth. Since monetary policy in the
conventional system is implemented through the central banks, in Islamic economics, the
central bank must conduct monetary policy to achieve the Islamic socio-economic
objectives. However, as stressed earlier, after nearly 25years in operation, central banks
in countries implementing Islamic banking and finance still follow the conventional
system of monetary policy. This necessitates the need to re-examine and assess whether
the Islamic prerequisites for the implementation of a successful monetary and financial
 105

policies such as the stability of the money demand function are valid for the countries in
question.

Monetary policy management through regulating money demand and supply is

fundamental under the Islamic financial and monetary system. This argument was first
promulgated by Mohamed Ariff (1982) who explained that an Islamic monetary policy
should be executed through controlling money supply (in the money demand function)
without using the prohibited interest-based instruments (Kiae, 2007). Other monetary
policy tools in the conventional system that do not involve interest rate charges such as
credit ceiling and moral suasion are equally valid under the Islamic monetary policy
framework (Ali, 1992).

Chulho and Ryu (2017) studied the conventional monetary policy as practiced in the
United States of America (USA). Their findings indicate that expansionary monetary
policy through policy cuts only helps big capital owners such as banks by increasing their
profits further but not the poor members of society. The implication here is that interest-
based MP limits the effectiveness of money supply as a tool of monetary management
since it concentrates resources in a few hands that own the required collateral for
borrowing. This argument is augmented by Goodhart (2015) who concluded that despite
bank rate cuts, the conventional monetary policy is comparatively ineffective and hardly
stimulates the economy from a depression and recovery periods.

Acharya et al. (2011) study found the nature of bank liquidity under the interest-based
monetary system counter cyclical in that it is excessively and substantially higher during
times of crises and extremely low during economic booms. Holding of such huge amounts
of liquidity by banks destabilises the velocity of money supply and thus makes monetary
policy less effective.

Awad (2015), studied the monetary policy practices of the economy of Sudan, paying
much attention to its compliance with the sharia principles. Specifically, he analysed the
different monetary policy instruments employed by the central bank of Sudan. He found
out that the loss and profit-sharing based instruments such as mudarabah and musharakah
fully compliant, compatible, and effective tools of monetary policy regulation.

Selim (2015) demonstrated how conducting open market operations based on buying and
selling of sukuk makes monetary policy more efficient and effective compared to the
 106

conventional interest-based system. In earlier similar studies, he had demonstrated that

sharia-compliant tools such as mudarabah and qardh hassan are not only more effective
but also very efficient in increasing total GDP, lowering unemployment and most
importantly ensuring sustainable financial and price stability (Selim, 2019).

Majid and Hasin, (2014) study analyses monetary policy transmission mechanisms and
channels. They found great limitations in the conventional monetary instruments that
limit money supply to banks with big capital and securities. The implication here is that
conducting monetary policy through a smaller section of financial institutions that take
full advantage of adjustments in the bank rate makes interest based monetary policy less
effective. Consequently, their study recommended that monetary authorities should
serious consider focusing on the Islamic finance modes and instruments as alternative
channels for monetary policy regulation in the economy. This is based on the fact that
interest free loans and deposits can play a quite significant role in monetary policy
management of any economy especially the percentages of Islamic banking and finance
has reached significant levels (Kassim et al., 2009).

Several other studies have embarked on efforts to develop Islamic monetary policy tools.
For example, Omar and Meera (2010) suggested that interest rate could be substituted
with arbitrage pricing theory (APT) whereby the returns on asset could be predicted based
on the linear relationship between the available macroeconomic variables that capture
systematic risks and the assets’ expected returns at a given time. Husin (2013) suggested
the use of profit rate as a monetary policy transmission channel although his suggestion
has been seen by many researchers as a disguised interest-based transmission mechanism.

Monetary policy transmission through shari’-compliant modes of financing facilitate real

sector expansion and growth (Gudarzi Farahani & Dastan, 2013; Majid & Hasin, 2014).
This is because, absence of interest rate charges lowers the cost of production, increases
the investment levels leading to a higher equilibrium output following an up shift of the
aggregate expenditure function. It is thus not an exaggeration to argue that the lower
economic growth levels amongst countries practicing Islamic banking and finance is
because of the growing tendency of Islamic banks in such economies preferring more risk
averse modes like murabahah to those that are riskier like mudarabah and musharakah.
This limits the full potential of Islamic financial and monetary system (Jedidia and
Hamza, 2014; Kayed, 2012).
 107

According to Adebayo and Kabir (2013), the Islamic universal ethical considerations and
principles embedded in the different modes of financing that are characterized buy a great
sense of compassion and flexibility renders them more effective in stimulating an
economy during periods of crises. Qardh-hassan for example offers the much-needed
flexibility and deferred repayment schedules to embattled business sector during times of
recession. Therefore, in comparison to the rigid conventional monetary system, a
monetary policy based on such interest-free instruments is more efficient and effective in
ensuring sustainable price and financial stability in any economy (Al-Jarhi, 1980).

Other studies suggest that if the monetary authority employs asset-backed securities as
instruments of monetary policy such as agency and leasing certificates, agency and
leasing sale certificates among others, otherwise known as wakalah wa ijarah and
wakalah wa ijarah Muntahia bitamlik respectively, the amount of money in circulation
can be altered in accordance with the aims of the central bank in question. In short, open
market operations based on such securities is more effective as compared to the debt-
based securities that characterise the conventional monetary system (Ismal, 2011).
Similarly, sukuk (interest-free bonds) are very effective tools that can alter the money
supply in any economy when used in the central bank operations such as open market
operations (Bidabad et al., 2011).

Abdulkarim (2016) studied the effect of financialization / monetisation of the economy

in OIC and OECD member countries. He found a positive nexus between financialization
and income inequality. This implies that as financialization grows, the rate of suffering
amongst the biggest cohort of the population increases due to higher income inequalities.
Accordingly, shari’-compliant financial and monetary tools that emphasize risk-sharing
as opposed to risk transfer practices. Unfortunately, many Islamic banks in dual financial
system continue to base their operations in many ways on the prohibited debt-based tools
(Alaabed & Masih, 2016).

Khatat (2016) demonstrated the challenges of pursuing monetary policy under a dual
monetary system. Complete consensus has not yet been reached on which tools should be
pursued to the satisfaction of the two banking industries. Accordingly, Selim & Hassan
(2018) proposed qard-hassan (benevolent loan schemes) pursuance as an appropriate
monetary policy instrument for the Muslim countries. Under this arrangement both
 108

conventional and Islamic banking and financial institutions have access to funds without
interest rate charges.

Asutay (2007) opined that since Islamic economics present a viable alternative system
within a political economic framework, practical suggestions aimed at accommodating
the monetary policy aspects of Islamic banking are necessary. Following his suggestion,
most of the scholars were focusing on Islamizing the instruments of the conventional
monetary policy in and suggesting a similar approach as far as the implementation of the
Islamic monetary policy is concerned.

4.3. Empirical related literature

Empirically, there are several studies that have employed different econometric models
in the analysis, development, and assessment of monetary policy under the conventional
monetary system. Several studies have investigated the monetary policy effects on the
conventional financial system (Ibrahim, 2005; Bernanke and Gertler, 2000). Similarly,
since the late 1980s through the recent past, various studies have increasingly paid
attention and investigated similar effects to the Islamic financial industry, proposed
management of the monetary system itself from the interest-free perspective among other
topics. Some of the studies are as follows:

Sari et al. (2017) investigated the possibility of adopting an interest-free monetary

framework based on equity premium. Adopting the DOLS estimation approach, their
study simulated the real GDP under sharia-compliant monetary system based on the
standard IS-LM framework. Employing time series data of Malaysian economy running
from 1980-2011, their findings could not approve equity premium but instead
recommended the adoption of the rate of return as an alternative to the prohibited interest
rate.

Majid and Hasin (2014) relied on the Autoregressive Distributed Lag (ARDL) bounds
testing co-integration model to explore the relevance of Islamic banks’ financing sector
in transmitting the monetary policy effects to the real sector of the economy. Their study
also uses quarterly data from 1991: Q1 – 2010Q1. The study confirmed the existence of
an Islamic financing channel for monetary policy transmission. Accordingly, they
recommended that since Malaysia is a dual monetary economy, the monetary authority
 109

should consider designing Islamic monetary policy alternative channels such as qardh-
hassan through which the Islamic monetary policy stance can be transmitted to the real
sector. Yusof et al. (2009) had made Similar recommendations based on the long-run
ARDL approach test results.

On setting benchmark rates for the market, different studies have proposed different
pricing mechanisms for the Islamic financing tools by estimating return on long-term
assets, return on equity (ROE), and Return on Assets (ROA), Lajis (2016), Mirakhor
(1996) extra. Other studies suggest the using of Gross Domestic Product (GDP) as a proxy
for estimating the rate of return (RoR) of the real sector ( Halid & Latiff, 2012; Hanif &
Sheikh, 2010; Şimşek et al., 2017).

Similar studies based on macroeconomic theory to suggest the use of conventional

monetary policy rates such as the overnight policy rate (OPR), Kuala Lumpur interbank
offer rate (KLIBOR), London interbank offered rate (LIBOR), interbank money markets
extra. Examples of such studies include Sheikh & Hahif (2009), Hassan & Kayed (2009),
among other studies.

Other studies that investigated the monetary policy application considering the Islamic
banking and financial institution for example efficiency and effectiveness of monetary
policy through Islamic transmission mechanisms such as mudarabah, musharakah,
Qardh-hassan, among others. Such studies as Gan & Yu (2009) on the Islamic monetary
policy rule, Asbeig & Kassim (2014) and Sukmana & Kassim (2010) on efficiency of
Islamic transmission mechanisms, Said & Ismail (2008) on lending behaviour of the
Islamic banks, capital requirements, monetary policy.

Askari et al. (2015) analysed the goals of the conventional central bank visa vis their
Islamic monetary counterparts. Over and above the macroeconomic goals of full
employment, low sustain able inflation rates that are normally pursued by conventional
central banks, the Islamic monetary system equally pursues other social-economic goals
such as providing social safety nets and minimising the income inequality and its
associated evils through such institutions as zakat, infaq, qardh-hassan among others.
This implies that economies with dual banking systems must ensure the steady
development of such tools that facilitate the broad aims of the shari’ (Islamic law).
 110

Yungucu & Sait (2016) analysed exiting literature concerning monetary policy effects on
the Islamic financial service industry. Their study affirmed the inexistence of clear
empirical models in the available literature at the time. Consequently, they developed a
new theoretical model based on the reviewed literature. Most importantly, however, the
results of their findings came down to two major points;1) apparently monetary policy
transmission has been and still takes place through the interest rate risk and asset-liability
mismatch, 2) The Islamic monetary policy (interest-free) is not only viable but as a better
alternative to the conventional monetary system that is based on interest.

In a related study, Abdullah (2015) investigated the negative impact of the conventional
monetary policies on both the conventional and Islamic banking and financial industries.
The study particularly looked at the monetary theory and banking practices of the
Malaysian economy by the money supply, GDP, interest rates and prices. He concluded
that the continuous monetary and financial instability is attributed to the conventional
monetary theories and policies. This implies that the implementation of Islamic monetary
policy tools becomes inevitable for the dual economies.

Ergeç and Arslan (2013) based on the Turkish economic data to examine the main
conventional monetary policy stance – the interest rate negative effects on the operations
and performance of the Islamic banking and finance industry. The findings of their study
revealed that changes in the interest rate negatively affects both the conventional and
Islamic banks deposits and loans. The existence of this correlation in terms of response
imply partially that the Islamic banking and financial institutions are technically operating
on the conventional system basis. This undermines the success and the credit that the
basic Islamic economic teachings of interest free monetary system. Similar findings had
been reached by earlier studies such as Kassim et al. (2009) on Malaysian economy.

Although usury is not allowed in relations between Central Bank of Iran (CBI) and Iranian
banks as well as between banks themselves. However, charging and payment of interest
among government entities is not considered usury (Maysami, 1999, p. 43). This
underscores the need to provide alternative means of monetary policy management as
opposed to the interest rate-based policies which most Islamic scholars agree that its
prohibition in all its different forms is absolute.
 111

In Economies where conventional finance predominates, competitive pressures may limit

the extent to which returns of PSIAs deviates from conventional banks’ deposit rates. As
a result, most of the Islamic banks and other Islamic financial institutions in dual financial
systems tend to link their mark-ups and returns of their contracts to conventional interest
rates. For example, in a 2011 study, Çevik and Charap (2011) found co-integration,
causality and volatility correlation between conventional and retail Islamic banks deposits
returns in the economies of Malaysia and Turkey.

As regards studies investigating the presence of long-run money demand and its
determinants as a basis for monetary policy implementation using appropriate
instruments, below are some of the empirical works.

Across the Islamic monetary policy literature, Darrat (1988) study in which he compares
the stability of money demand under the interest free banking system vis-à-vis the
conventional banking system seems to be the foundation of much of the empirical works.
Using Tunisian economy data set, he concluded that interest-free money is relatively more
stable compared to the interest-based one. However, since Tunisia has no history of
Islamic banking at the time of his study, it cast a lot of doubt on his findings. Therefore,
accordingly, following Darrat (1988)’s approach, Yousefi et al. (1997) conducted a
similar study based on data from the Iranian economy, a country with a strong history of
Islamic banking and finance. Surprisingly, their findings confirmed Darrat’s findings.

Kia and Darrat (2007) based on the Iranian monetary data since its adoption of a fully
Islamised economy and assessed the long-run stability and policy invariances by
modelling money demand under the loss and profit-sharing banking scheme. Their data
period spanned from 1966-2001 covering the before and after Islamisation periods of the
Iranian economy. They estimated two alternative demand equations for M1 and profit-
sharing deposits using DOLS. Results of their study findings augment and suggest the
adoption of risk and profit-sharing as an effective and efficient instrument of monetary
policy regulation. This was anchored on the stability and resilience to both policy and
non-policy shocks that the money demand function of Iran exhibited.

Hamid et al., 2015 examined the influence of determinants of money demand including
income, interest rate and exchange rate across GCC countries. Their study revealed a
positive income influence, negative interest rate influence on money demand. For
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exchange rate however, it was insignificant for all counties apart from the kingdom of
Saud Arabia. Their study seemed mis-specified as a very important variable of expected
inflation rate was not considered in their estimations.

Darrat (2002) empirically assessed the merits and relative efficiency and policy
usefulness of the interest free monetary system using Pakistan and Iran as case studies.
Based on cointegration and error correction methodologies, he used data sets that spanned
from 1960-1999 paying special attention to the period starting 1980s when both countries
seriously embraced Islamic banking and finance practices. Although his study findings
support the efficiency and policy usefulness of the interest free banking system hypothesis
over the interest-based system, he recommended further studies in the area to augment
his findings. This study attempts to fill this gap in literature.

Bahmani-Oskooee and Economidou (2005) investigated the money demand function in

case of Greece using M1 and M2. Applying a cointegration approach on quarterly data
from 1975-2002, they revealed that the elasticity and the semi-elasticity coefficients of
the income and interest rate variables carry the expected signs as the case for the above
studies. On stability, while they found M1 stable, M2 was found to be unstable.

Capasso and Napolitano (2012) employed an ARDL model on a time-series that spanned
from 1977-2007 in Italy. Their findings indicated that the effects of income and interest
rate on money demand are not any different from those reached above by other
researchers. In a similar study using the same testing technique Baharumshah el al.,
(2009) found similar results when they investigated the money demand function in case
of China.

In another study, Foresti and Napolitano estimated a panel DOLS and between-dimension
group-mean panel DOLS. Their study was investigating the presence of a long-run money
demand in a group of nine developed OECD countries. They used two alternative scale
variables (income and wealth) to model two money demand functions using quarterly
data running from 1982-2008. Their results highlight the role of wealth in determination
of money demand with a positive elasticity coefficient. Comparing income and wealth
parameters in terms of stability analysis, their findings suggest that the estimated money
demand where wealth is included seems more stable than the case for income.
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4.4. Conclusion

In conclusion, whereas a lot of development has taken place in relation to the development
of the Islamic banking and finance sector, there has not been much attention given to the
monetary policy aspect and yet it forms the core of any macroeconomic policy of an
economy. Evidently, there is little empirical work on regarding the practicality of
monetary policy management. Besides, previous studies by Darrat (1988), Hassan (1998)
and Yousefi et al., (2001, 2010) recommended further research on the area. Specifically,
Hassan (1998) recommended a cointegration analysis to study further the stability of the
money demand function for both Islamic and conventional economies.

This study thus attempts to fill this gap in literature by using panel FMOLS, DOLS and
ARDL model to examine not only the viability of an interest-free monetary policy but
also assessing its relative stability and effectiveness over the conventional one. Most
importantly, whereas the stability of the money demand function as a prerequisite for
effective monetary policy management was noted as necessary condition in many studies,
there has been a general lack of empirical support for the same under the Islamic monetary
policy perspective. This study seeks to close these gaps in literature.
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CHAPTER FIVE

SUPERIORITY OF THE ISLAMIC MONETARY SYSTEM BASED

ON ITS THEORETICAL AND DIVINE FOUNDATIONS

5.1. Introduction

The basis and foundations of the Islamic financial and monetary system are in divine
scriptures and the traditions of the Prophet Peace Be upon Him (PBH). In various chapters
of the Holy Quran, the epistemological roots for the belief that an interest-free financial
and monetary system is more effective and efficient over the convention one in facilitating
the achievement of macroeconomic goals, is categorically and emphatically stated
(Erdem, 2017; Iqbal & Mirakhor, 2011). The following verses are examples of such
verses addressing the issue:

Allah says:

“…and that man shall have nothing but what he has striven for, and that (the result
of) his striving shall soon be seen, and that he shall then be fully recompensed…”
(An-Najm: 39-41).
“Woe unto those who give short measure. Those who, when they are to receive their
due from (other) people, demand that it be given in full, but when they have to measure
have to measure or weigh whatever they owe to others, give less than what is due”.
(Al-Mutaffifin:1-3).
“Oh ye who believe! Eat not up your property among yourselves unjustly except
it be a trade amongst you, by mutual consent... Surely, Allah is Most Merciful to you”.
(An-Nisa :29).
“As for those who devour interest, they behave as the one whom Satan has confounded
with his touch. Seized in this state they say: “Buying and selling is but a kind of interest,
 115

“even though Allah has made buying and selling lawful, and interest unlawful. Hence,
he who receives this admonition from his Lord, and then gives up (dealing in interest),
may keep his previous gains, and it will be for Allah to judge him. As for those who
revert to it, they are the people of the Fire, and in it shall they abide”
(Al-Baqarah: 275).
While the verses in surat an-Najm and al- al-Mutaffifin above were revealed during the
early Meccan period of Prophet Muhammad’s mission (PBH) (before hijirah), that of
surat an-Nisa was revealed in Medina after the Islamic state had been formed (after
hijirah) and the last verse was revealed in the last days of the Prophet (PBH). Despite the
divergence in periods, places and circumstances leading to these revelations, the principal
message of earning income and wealth through mutual trade and offering of labour was
maintained. Beside the ban on interest, Islam recognises the dynamics of handling money
to both consumers and investors. Accordingly, Allah recommends that the debtor should
be given more time, or the debt should be waived off if he or she is not able to pay on the
agreed upon date.

Allah says: “If the debtor is in difficulty grant him time till it is easy for him to repay.
But it ye remit if by way of charity that is best for you if ye only knew.” Al-Baqarah, 280)

So, for any financial and monetary system to prosper, it ought to adhere to the divine
guidance and principles that govern market structures as laid down in the Holy Scriptures.
In the very basic sense, for any economic system to truly prosper, it should be centred on
trade and offering of labour services for production as opposed to offering of interest
based loans (Erdem, 2017; Karaman, 2006).

Besides, as pointed out in chapter three, it is not only the Holy Quran but even earlier
revealed scriptures including the Bible and Torah explicitly condemn and prohibition
lending and or doing any form of business based on charging and receiving of interest.
Instead, benevolent lending schemes (qardh-hassan) and mutual partnerships
(musharakah, mudarabah, extra) are encouraged for the prosperity and wellbeing of
humanity. Mutual partnerships substantially solve and mitigate the challenges moral
hazard and adverse selection that are associated with asymmetric information (imperfect
knowledge) in the money market (Erdem, 2017). This in a way makes the Islamic
financial and monetary system undoubtedly more effective and efficient.
 116

The Bible says: “…And if you lend to those from whom you hope to get money back, what
credit can you expect? Even sinners lend to sinners to get back the same amount. Instead,
love your enemies and do good to them, and lend without any hope of return. You will
have a great reward” (Bible, Luke: 6:34-35).

The Torah says: “If you lend money to My people, to the poor among you, you are not to
act as a creditor to him; you shall not charge him interest” (Torah, Exodus: 22-25).

From the above divine citations, the Islamic finance and monetary system is superior to
the manmade system. In fact, nearly all Christian societies had always condemned and
considered incomes from interest as illegitimate until the Middle Ages, under the
influential teachings of John Calvin (Bekci, Apalı & Apalı, 2014, p. 6).

Other surahs of the Holy Quran; 57:18, 2:245, 73:20 among other issues stress the benefit
of ethical and moral lending on an interest-free lending simulacra evaluation basis. Over
and above practicing it himself, the Prophet (PBH) is reported to having emphasised and
elaborated the need and importance of interest-free financial system in the following
hadith:

“… the reward for lending is repayment and words of paradise.” (Muslim, 1224/3).

While explaining the divine guidance, the prophet directed and guided the
implementation of a socio-economic-political life of the new Islamic life (Iqbal and
Mirakhor, 2013). Specifically, he stressed and encouraged believers to offer loans based
on qardh hassan in the following traditions:

“A Muslim is the brother of another Muslim. He neither wrongs him nor leaves him in the
lurch. And he who meets the need of his brother, Allah will come to his aid in the hour of
his need. And the person who removes the distress of another Muslim, Allah will relieve
him from the distraction of the Day of Reckoning…” (Buhârî, 2000; Mezâlim, 3; Müslim,
1979).

“Whoever allows more time for a debtor who is in difficulty or waives the debt, Allah
will shade him with His shade. Beware, paradise is the like the stone on a steep hill.
Rasulallah has repeated it three times...” (Ahmad, 2005, 2:327).
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“Whoever wants Allah to answer his prayers and the difficulties to vanish, should help
someone in difficulty” (Ahmad 2005, 2:23).

“Whoever relieves a believer’s distress of the distressful aspects of this world and relieves
him, Allah will rescue him from a difficulty of the difficulties of the Hereafter. Whoever
alleviates [the situation of] one in dire straits who cannot repay his debt, Allah will
alleviate his lot in both this World and in the hereafter... Allah Is helping the servant if
the servant is helping his brother…” (Buhârî, 2000, Mezâlim: 3; Müslim, 1979, Zikr: 38;
Ebû Davûd, 2000).

In his famous last sermon (Khutbah wida) in which he profiled the basic human rights,
Prophet Muhammad (PBH) emphasized the prohibition on interest when he said:

“... Oh People, just as you regard this month, this day, and this city as Sacred, so regard
the life and property of every Muslim as a sacred trust. All the vicious matters (riba) that
belong to the jahiliyyah have been waived, it is under my feet. Your capital, however, is
yours to keep. You will neither inflict nor suffer inequity … all the interest due to Al-
Abbas ibn Abd’el Muttalib shall henceforth be waived...” (Erul, 2012, p. 592; Müslim,
1979, Hac: 147; Ebû Dâvûd, 2000, Menâsik: 56; İbn Mace, 2000, Menâsik, p. 76, 84).

Therefore, based on the above quotations and indeed many more, the Islamic financial
and monetary system takes its origin from the divine will that has guided human beings
since the first creation of mankind. As the last generation of mankind, those principles
have been stated for us in the holy Quran and the traditions of the Prophet Peace Be upon
Him (PBH). Once adhered to, the economic system can undoubtedly perform effectively
and efficiently.

For example, according to historical accounts, it was the efficiency and effectiveness of
the Islamic financial system during the reign of Umar bin Abdul-Aziz that reduced poverty
levels so much so that no person poor enough to receive zakat remained in the vicinity of
the Islamic state (As-Sallabi, 1999, p. 574). So, it is plausible to argue that the
effectiveness of the Islamic financial system has been tested and proven.

Also, during the Sarrafiin period, financial institutions helped each other to overcome
liquidity shortages through such Islamic contracts as qardh hassan, musharakah,
mudarabah, among others (Chapra and Ahmed, 2002). Some contemporary studies have
 118

indicated that if Islamic financial system in its true sense is implemented, absolute poverty
would significantly be reduced or even eradicated among the Muslim countries especially
through the institution of zakat (Islamic Social Finance Report, 2014).

Although they took different paths of development, there is evidence that many economic
principles in the conventional system were borrowed from the Islamic system because of
its remarkable success (Çizakça & Murat, 1996, 2006)37. According to Ahmed (2008),
some finance and monetary concepts of the conventional system are like those of the
Islamic system. Other studies allege that the basic foundations of many conventional
finance and monetary concepts, contracts, practices, and institutional instruments trace
their origin to the Islamic legal regimes. However, they have since been changing to
reflect different concepts that conform to secular ideologies (Chaudhuri, 1983; Cizakca
& Murat, 2006). As pointed earlier, it is not surprising that Medieval Europe considered
charging interest as an “economic evil, a heinous crime” and therefore severe
punishments were levied and ordered onto anyone found guilty/culprit to its practice.
Also, very stringent measures were put in place to implement its prohibition38.

Also, Adam Smith who by many standards is considered the origin of modern economic
system shared the key fundamentals and institutional scaffoldings of Islam in his
publication of the Theory of moral sentiments (Smith [1759] 2006, 186-189). It therefore
follows that Smith’s famous book of Wealth of Nations cannot and should not be read in
isolation of the theory of moral sentiments to avoid a gross misinterpretation and
misrepresentation of an ethical-moral and efficient economic system based on divine
guidance as Smith envisioned (Walsh, 2006, P. 6).

The next section looks at the Islamic money demand theoretical framework and its
relative superiority over the conventional one. The section equally takes an overview of
the different monetary theories, aimed at ascertaining whether the Islamic monetary
policy practices are underpinned by or in conformity with the general monetary literature
available. This superiority is then empirically tested based on the analysis of the relative
stability of the money demand function in the next chapter of this study.

37
See also Abraham L. Udovitch, At the Origins of the Western Commenda: Islam, Israel, Byzantium? 37
Speculum 198 (Jan. 1962).
38
Also, Barren Metal: A History of Capitalism as the Conflict between Labor and Usury Hardcover –
2014https://www.amazon.com/Barren-Metal-History-Capitalism-
Conflict/dp/0929891147/ref=asap_bc?ie=UTF8
 119

5.2. The theoretical framework on demand for money

Across major macroeconomic theories, quite a reasonable number of monetary

economists strongly contend that a well-behaving and stable money demand function is
a very important condition for the smooth management and effectiveness of monetary
policy (Uddin, 2016). Other studies have pointed out, however, that with endogenous
money supply, money demand may not be of any practical significance (McCallum &
Nelson, 2010). Our study considers the former, which is the dominant view over the latter.
To assess the relative superiority and effectiveness of the Islamic monetary system over
the conventional monetary system, we have based our study on the hypothesis that the
former is relatively more stable compared to the latter.

5.2.1. Variables in the demand for money

There is a divergence of opinions as regards the demand for money. Most importantly,
however, a great deal of the surveys on money demand theories in the conventional sense
start with quantity theory of money. So, it is easier to compare and differentiate the
varying views using the quantity theory (Bain & Howells, 2003). As stated earlier in
chapter two, the most familiar version of the quantity theory is Fisher’s (1911) ‘equation
of exchange’ as stated below:

(5.1)

Where; = stock of money, velocity of money in circulation, the general price

level of goods and services and total volume of transactions. The equation implies
that the total quantity of money in circulation is related to the volume of transactions
(output) and the price level of commodities through a proportionate factor known as
velocity. The quantity of money in circulation reflects the proportion of the total volume
of goods and services transacted (Erdem, 2017).

The above equation is associated with the classical view of macroeconomic theory. Under
this view, money is demanded as a medium of exchange, to facilitate transactions.
Therefore, by itself, money has no intrinsic utility. Like any other theory, this theory is
based on some assumptions. For example, it assumes the existence of full employment
equilibrium where there is a stable ratio between the volume of transactions and total
output in the economy. when , and M are assumed to be exogenous and taken as
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constant, when the central bank alters the size of monetary base at will, other factors
equal, the effect runs from money supply to prices as shown below.

(5.2)

is normally considered the most active “important” variable of the equation of

exchange and is the “passive” one (Schumpeter, 1954). The bars over , and T
signify that these variables are determined independent of others (exogenously). The
equation thus assumes the following form:

(5.3)

The expression above expounds the monetary neutrality principle in that an exogenous
expansionary policy fine-tuning leads to a proportionate increase in the price level but
does not affect the real factors of the economy such as real income and employment levels
in the economy. This principle holds under the classical assumption of the existence of
two non-interactive sectors, the nominal, and the monetary sector (classical dichotomy).
So, T (volume of transactions (real output)) is determined by the supply side of the real
sector and no monetary policy (M) changes can influence it (Erdem, 2019).

In the cash balance approach (Cambridge school) promulgated by the neoclassical

economists especially Pigou (1917) and Marshall (1923), the importance of money
demand and income is stressed by giving the quantity theory an alternative paradigm.
Under this approach, money is not only a medium of exchange, it is also a store of value
and people wish to hold part of their real resources in form of money (Keyder, 1993, p.
243; Paya, 1994, p. 43). Pigou (1917) argues that ceteris paribus, money demand, , is
proportional to the income level, Py, such that . But the actual concern is on
the real value of the demanded money. Therefore, the equation transforms into the
following:

(5.4)

Where; the real money demand, p= the price level, y = the wealth /resource incomes

and the Cambridge k expresses the relationship between them. The ratio k of the nominal
incomes that an individual hold in his cash balances might depend on the rate of interest
and the level of wealth. Assuming k ratio as a constant, we can draw similar policy
 121

message as we did under Fisher’s quantity theory (Bain and Howells, 2003). So,
conclusively, the two versions of the quantity theory appear similar in that in bother cases,
if money is taken as exogenous, excess money supply leads to increases in the price level
(inflation) (Erdem, 2019). The demand for money function in the Cambridge is stably
related to wealth (w) / income resources and, and henceforth to T. Since k ratio is assumed
constant, at full employment, the principle of money neutrality holds in the Cambridge
formulation too.

The third view was developed by Keynes (1936). In his general model, which relates to
the short-run income, output, and employment determination. In terms of the Fisher
equation, T is replaced by y and it is subject to change. This is because, contrary to the
classical view of perfect price flexibility, Keynes argued that prices are fixed in the short-
run and therefore real and monetary sectors of the economy are interdependent. So, the
classical dichotomy does not hold in the Keynes model (Motyovszki, 2013). Keynes
stated that people hold money for three motives as follows:

First as a medium of exchange, to buy commodities (transaction motive), second, to edge

against any emergencies (Precautionary motive). This depends on the amount of
transactions; then, money demand is positively related to income also for this motive
(Froyen, 1993: 62). The third one, money can be held as a store of wealth or in bonds. In
other words, there are two alternatives in which wealth can be kept. So, Keynes
introduced interest rate into the money demand function under what he called the
speculative motive of holding money. As interest rate increases, it is expected to decrease
and the bond prices to rise. Accordingly, he incorporates two variables whereby:

, (5.5)

Where; real money demand, y = real income that mirrors the transaction and

precautionary demand motive for money, and i = interest rate which reflects the
opportunity cost for holding money. Other models that have been developed on this basis
include Baumol (1952) and Tobin (1956) models.

For the monetarist school, the demand for money is not any different from other assets.
According to Friedman (1956), the real money demand is positively related to the
permanent income and expected return on money. Money holding is negatively related to
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the expected inflation and expected return on other money alternative assets such as
equity and bonds. For Friedman, economic agents hold money as a durable good to be
used in future purchases, implying that money is an “abstract purchasing power”.
Accordingly, the money demand model is expressed as follows (Hubbard, 2004; Mishkin,
2001).

, , , (5.4)

Where; real money demand, permanent income, Expected return on

money, Expected rate of return on equities, Expected return on bonds,

Expected inflation rate.

Under this view, money demand is considered insensitive to the interest rate in that as the
interest rate rises, the expected rate of return on money held as bank deposits, , rises
along with the expected rate of return on other alternative assets, and .Therefore,
the opportunity cost variables , and cannot produce any
significant change in the real demand for money. Therefore, real demand for money is
determined solely by changes in the permanent income, which is a measure of wealth.

In summary, the demand for money is a positive function of all the wealth (resources)
that an individual possesses and a negative function of the expected rate of return on
equities and bonds relative to the expected rate of return on money (Foresti & Napolitano,
2013). The wealth effect may be positive or negative (Friedman, 1988). A positive effect
may happen under three circumstances. First, an increase in the prices of assets implies a
rise in the volume of their transactions, thereby prompting an increase in the money
demand to facilitate the increased volume of transactions (reverse causation espoused by
the real business cycle theory). Second, a rise in asset prices leads to accumulation of
additional wealth, part of which may be stored in money form. And lastly, third, an
increase in asset prices reflects an increase in the expected rate of return from risky assets
with respect to the risk-free ones. For the negative substitution-effect to occur, it suggests
that a rise in asset prices reduces the attractiveness of holding money as a component of
one’s portfolio.

The major difference between the monetarists led by Friedman (1956) view and
Keynesians led by Keynes (1936) in respect to the money demand theory is about
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stability. The former argue that the permanent income wealth is a more stable indicator
than current income proposed by the latter. Accordingly, money demand is believed to be
stable and so the monetary authorities can control it thereby rendering monetary policy
very effective. In contrast, the Keynesian view argues that money demand is relatively
unstable and money supply as a monetary policy tool is beyond the control of the central
bank. Consequently, monetary policy is very ineffective when compared to fiscal policy.

Under the Islamic finance and monetary system, the demand for money consists of two
major components (motives): transaction demand (demanded for its function as a medium
of exchange that facilitates the payment system) and precautionary demand. The latter
entails the desire to help those in need and avoid the embarrassment of failing to help the
needy and destitute in the society (Uddin, 2016). For example, the numerous verses of
the Holy Quran and various traditions of the Prophet (PBH) that emphasize the qardh-
hassan principle as cited earlier serves to argument this postulation (Chapra, 1996; Khan
& Mirakhor, 1994).

Also, there are some other two additional important components of money demand.
Firstly, the absence of interest rate in the economy implies that the speculative demand
for money is expected to significantly be minimised or even absent after the economy has
fully adopted the Islamic mode of economic order (Chapra, 1992; 1996). The minimised
speculations are further translated into profit-loss sharing ratios that are calculated based
on real commodity prices prevailing in the open market during a particular period (Bm &
Uddin, 2016). As this ratio rises, the speculative tendencies decrease and vice versa when
it falls. Secondly, the existence of the zakat system in the economy implies that wealth
holders are expected not to hold money more than their transaction and precautionary
needs.

The implication here is that as they invest and re-invest their excess liquidity in shari’
compliant ventures to avoid the erosive effects of zakat and inflation tax, the expected
rate of return with its multiplier effect accelerates the achievement of macroeconomic
goals of the economy such as sustainable high output and low employment rate in the
economy. So, the Islamic financial and monetary system is characterised by the existence
of a positive relationship between investment and the expected rate of return. Most
importantly, the transaction demand for money is expected to be relatively more stable as
 124

compared to the conventional system as a result of consistent expected rate of return due
to absence of interest rates (Soliman, 2016).

In order to regulate the money demand, the Islamic economic system relies on a number
of strategies include: (i) a socially agreed filter mechanism (a moral filter which is
sanctioned by adherence to divine guidance as cited earlier and the belief in the life-after
death)39 (ii) a strong motivating system to induce the individual to render his best in his
own interest as well as in the interest of society by being accountable to Allah and
believing in the life after death40 (iii) restructuring the whole economy with the aim of
realising maqsid shari’ despite scarce resources The restructuring process should
incorporate using resources conscientiously as Allah’s trustees (Quran, 2:30), payment of
zakat and other Sadaqat as a means of social-help (Quran, 9;60), inheriting resources of
the deceased according to the stipulated rules laid down by Allah (Quran, 4:11) and
financial system rearrangement and reorganisation (iv) the last strategy concerns a
positive goal-oriented role for the government whereby it undertakes a moral obligation
that ensures that the social and private interests are pursued in a balanced manner for the
greater well-being of the present and the future generations. This should be done with
wisdom and through consultations41 as a strict requirement in all Islamic crucial matters
(Qur’an, 2: 256 and 16: 125) (Chapra, 1992).

These elements combined significantly minimise instabilities in aggregate money

demand in the economy in a manner that promotes greater efficiency and equity in the
use of money (Uddin, 2016). The velocity of circulation of money is expected to observe
greater stability due to the relatively greater stability in the money demand under an
Islamic financial and monetary system. Besides, the asset-backed principle of a valid

39
This is a key requirement for all believers as mentioned in surat al Maida where Allah says: “Believers!
… help one another in acts of righteousness and piety, and do not help one another in sin and transgression.
Fear Allah. Surely Allah is severe in retribution (Al-Maida: 2).
40
Also, strategies (i) and (ii) implies that the individual who adheres to divine guidance cannot indulge
him/herself in the production and trade of morally questionable activities. Also, he is motivated to do his
best to gain in the world but with a binding social/ corporate responsibility to help others with hope that his
efforts shall be compensated in the life after death. Allah says: “But seek, with the (wealth) Which God has
bestowed on thee, The Home of the Hereafter, Nor forget thy portion in this World: but do thou good, As
God has been good To thee, and seek not (Occasions for) mischief in the land: For God loves not those
Who do mischief.” (Al-Qasas: 77).
41
For the state to undertake this responsibility, it should not turn out to be the police on the society but
rather ought to rely on its most knowledgeable members in the matter at stake and discuss comprehensively
so as not to be seen to stifling private initiatives and innovations. ALLah says: Those who hearken to their
Lord and establish Regular prayer; who (conduct) their affairs by mutual Consultation; who spend out of
what We bestow on them For Sustenance” Al – Shurah, 38).
 125

Islamic contract implies that the divergency between the real and the nominal sectors are
significantly reduced and therefore the “classical dichotomy” assumption may not hold
in an Islamic economy (Al-Jarhi, 2005).

A stable money demand requires that the supply of money ( is equally stable.
According to Kia and Darrat (2007), the monetary authorities under the Islamic monetary
system can keep the economy at its optimal level of money supply by targeting the
appropriate monetary aggregate. This is especially true when one considers the full
information disclosure requirement for the validity of an Islamic contract and the
significant litigation effect on adverse selection and moral hazard challenges that emerge
from asymmetric information in the money markets (Erdem, 2017)42.

Since complete disclosure of information is one of the key principles of a valid contract,
it is plausible to argue that under a full-fledged Islamic economy, the central bank can
operate at the optimal level as market inefficiencies especially adverse selection and
moral hazard caused by asymmetric information are litigated. At this level, the consumer
surplus is maximised. This is not alien to the conventional monetary literature. For
example, according to Friedman (1969), the optimum level of money supply can only be
achieved when the rate of interest is zero.

Conclusively, as seen from the foregoing discussions, every macroeconomic theory has
its own unique postulation as regards the money demand function. However, taken in
general terms, the economic theory states that empirical analyses are generally carried out
on the assumption that money demand is a function of a scale variable to measure the
economic activities and a vector of opportunity costs (Foresti & Napolitano, 2013). A
basic representation of the long-run demand for money function can be expressed as
follow:

, (5.6)

Where; the real money demand as a function income (Y) and of some opportunity

cost variable such as expected inflation rate, expected return on money extra. As pointed

42
The prophet (PBH) is reported to have warned both sellers and brokers against dishonesty. On the former,
He said: “The one who misleads us is not of us” (Davudoğlu, 1977/C1: 406-7). On the latter, he always
warned middlemen (brokers) against swearing and using empty word much gently (Kallek, 1997: 178).
 126

out earlier, the real money demand has a positive relationship with the real income and a
negative one with the opportunity cost variables. Under an exogenous money supply
assumption, Friedman (1970) argues that the causality runs from left to right (money
supply determines the price/inflation rate) and the demand for money is a function of a
small number of variables (Bain & Howells, 2003).

In our study, we adopted a restructured form of Friedman’s (1956) model that considers
the real money demand as an extension to the theory of demand for durable goods as shall
be elaborated in chapter six. We specifically apply an augmented version of the equation
(5.6) as applied in most recent studies of the money demand function cointegration
analysis (Foresti & Napolitano, 2013). The augmented version is expressed as follows:

, , (5.7)

Where; demand for real money balances as a function of real income as a scale

variable to measure economic transactions (Y), expected inflation rate as the opportunity
cost variable (OC) and real effective exchange rate as among other variable (X) that affect
the real demand for money.

5.3. Sources of Inflation

Since money is neutral and super-neutral in the long term from the conventional economic
theory, the monetary authority ought to comprehensively understand the economy’s
money demand function as an essential precondition for the achievement of
macroeconomic goals in a sustainable manner, especially sustainable price and financial
stability. This argument is anchored on the fact that sustainable price stability creates a
feasible economic environment in which both consumer and production investment
decisions are taken, thereby yielding sustainable rapid economic growth (Hossain, 2016).

Otherwise, instability due to inflation hurts the poor more and worsens their well-being
(Easterly and Fischer, 2001). Moreover, if it persists for longer periods, it creates
economic stagnation because of crippling effective decision making for both active and
prospective investors thereby lowering aggregate demand. This leads to high
unemployment levels thereby hurting the poor cohorts of the population (Ball, 1992;
Romer and Romer, 1998; Friedman, 1991, 1994). For that reason, therefore, the money
 127

demand function has been the most fundamental building block in macroeconomic
modelling as a framework for monetary policy design and implementation as indicated in
various studies such as Anderson and Rasche (2001), Ball (2001), Miyao (1996), Stock
and Watson (1993), Hoffman and Rasche (1991) among others.

Over the years, however, consensus has been building on the fact that the most important
issue in monetary economics is analysing the source of inflation (Parkin, 1992). This is
because, once the source of inflation is identified, it becomes easier for policymakers to
design the necessary monetary policy frameworks to control inflation. This section thus
provides an insight into the different views on the sources of inflation as put forth by the
most prominent schools of macroeconomic thought and their subsequent monetary
theories. The inflation literature begins with the classical theory of inflation.

5.3.1. The classical theory

The classical school of economics is founded on the assumption that prices are perfectly
flexible and therefore money is neutral in the long run. The classical belief alludes that
an economy has an inherent automatic adjustment mechanism whereby supply creates its
own demand as stated in “Say’s law”. So, markets are always able to clear perfectly
(Nomine, 2010). According to this view, real GDP in an economy is determined by the
real supply fundamentals, labour and capital and their respective productivity. The
founders of the classical economic theory including Adam Smith, David Ricardo and
John Stuart Mill were all concerned with the overall long-run economic growth of an
economy. Overlooking the short run business cycle fluctuations, they contended that
inflation in the long run is determined by the growth rate of the money supply (Baer and
Kertenetzky, 1964; Johnson, 1972).

However, there were some classical economists who expressed their curiosity into
inquiring on the relationship between inflation and unemployment in the short-run
periods (Humphrey 1985). Such works by Thornton (1802), Irving Fisher (1926), and
David Hume (1952) are always sited as good examples in the above regard.

In further explaining the working of an economy as regards monetary policy, they divide
the economic operations into two non-interactive sectors as noted earlier; the real and
nominal sectors, in what later came to be known as the “classical dichotomy”. Real
 128

economic output is a function of real fundamentals from the supply side such as labour
and capital. So, nominal changes such as money supply changes can only result into
changes in price levels but no real variable effects at all (Nomine, 2010). Money is neutral
and therefore no change in the quantity of money can bring about real change in demand.

The classical economists’ argument stresses that much as non-monetary factors affect
inflation; the effects are only transitory in nature. Non-monetary factors originating from
both the demand side and the supply side, cannot lead to a self-sustaining inflation without
monetary accommodation (Romer, 1990). Therefore, control of money supply implies
long-term inflation growth rate control (Friedman, 1983). An analysis of the linkage
between the money stock and the price level across the monetary literature commences
with Irving Fischer’s Quantity Theory of Money (1926), expressed in the form of the
well-known Equation of Exchange below:

(5.8)

Where (M) is the money stock, (V) is the velocity of circulation of money as earlier
defined. (P) is the price level and (Y) is the real output on which spending is made. With
the classical assumptions cited earlier, the equation of exchange implies that the money
value of expenditure (MV) equals the money value of output bought (PY). Equation can
be expressed in the form of proportionate changes in variables, such that:

GM GV GP GY (5.9)

The above equation is built on the assumptions of the classical theory. The implication of
the above equation is that the sum of the proportionate changes in money (GM) and
velocity (GV) equals the sum of the proportionate changes in the price level (GP) and
output (GY). The quantity theory therefore suggests that there exists a one-for-one
proportional relationship between money supply growth (GM) and inflation (GP) under
the assumptions stated earlier in equation (5.3) (Orhan, 1984, p. 12). Therefore, once the
supply of money is controlled, inflation will automatically be kept under control
(Friedman, 1986). Money demand functions that are based on this theory include Irving
Fischer (1911)’s classical quantity theory of money, the Cambridge approach of Marshall
and Pigou to the classical quantity theory, extra.
 129

The classical theory arguably and notably seems the closest in conformity and
compatibility to the tenets of an Islamic monetary and policy system in several ways
(Hossain, 2009). For example, first, like the Islamic economic teachings, the classical
theory links price to money at its base as explained in the equation of exchange above
and makes a distinction between money and credit43. While the central bank controls
money supply, it is the interaction of the market forces of money demand and supply that
determines the price level in an economy. For this reason, hoarding of goods to the
velocity of money and create artificial scarcity with intent to defraud the customers
through higher prices is condemned strongly (Al-Sadr; 2000, p. 212). And in turn value
of money is determined by the price level. Any discrepancy between money demand and
money supply is automatically adjusted through changes in the price level. As a proxy for
wealth, the real income fundamentally determines the demand for money.

The classical-Monetarist theory postulates that interest rate does not significantly
influence money demand. This is because, under their perfect competition assumption
whereby the nominal prices adjust freely following changes in demand and supply, the
relative returns on money and alternative assets remain largely unchanged. This implies
that the price level may remain stable when the money supply changes predictably in
proportion to any rise in money demand following an increase in the volume of
transactions (income) (Friedman, 1956, 1969).

Under the Islamic economic system, money is equally different from credit. Accordingly,
money is not capital, but it is instead potential real capital. Unlike money which is treated
as a flow concept and a public, capital is a stock concept and a private good (Mujahidin
& Muhamad, 2019). Therefore, from the Islamic perspective, money cannot earn money
(returns) by itself but instead only earns a profit after being transformed into real capital
by the entrepreneur. In other words, money can only earn a return after being deployed in
the real sector productive activities that generate a stream of profits that then are shared
between the contractual partners in accordance with the pre-agreed upon profit ratios
(Erdem, 2017). This implies that money holders in the Islamic economy are not lenders

43
According to Hossain (2015), credit basically represents a transfer of purchasing power for a specified
gain in return while money is considered an asset. Interest is not a price for money but rather a price of
credit (loanable funds) which is determined in the credit market by the interaction of credit supply and
credit demand forces.
 130

as in the case of conventional system, instead, they are equity-holding business partner in
a profit-loss sharing framework.

As cited earlier from the key Islamic sources of (Holy Quran and the Traditions of the
Prophet (PBH)), the Islamic financial system nullifies any financial dealing that is
undertaken based on debt finance. Wealth creation in Islamic economic teachings is
anchored on combining labour and physical capital to produce goods and services, that is
then exchanged through trade for the well-being of society. Therefore, the opportunity
cost of holding money is not the interest rate but rather the profit expected from the use
of money as capital in a productive active as underpinned by the following verse of the
Holy Quran. Allah says:

“…and that man shall have nothing but what he has striven for, and that (the result of)
his striving shall soon be seen, and that he shall then be fully recompensed…” (An-Najm,
39-41).

5.2.2. The Keynesian View

Although J.M Keynes was first an advocate of the classical views, he later became one of
its greatest critics (Kazgan, 1984, p. 263). His views emerged following the great
depression of the 1929-1932 that shook up the basic foundations of the Orthodox classical
theory. According to the Keynesian view, contrary to the classical theory perceptions and
beliefs, economic activities in the real sector are driven by the demand side variables,
particularly in the short run. Keynesian economists base their assertion on the fact that in
the short run, wages / prices are either perfectly fixed or sticky through contracts (Froyen,
1993: 677; Romer, 1990)

Therefore, the equilibrium in the market is always below the full employment levels in
the economy. On this basis, policy induced aggregate demand changes result into real
variable effects in the short run that help to drive the equilibrium to its full employment
level. Although Keynes agree with the classical view that in the long run, such policy
shocks are absorbed by the economic agents and therefore the economy converges back
to its equilibrium steady state, he dismisses such claims asserting that we shall all be dead
and non-existent in the long run.
 131

Otherwise put, the effect of increasing money supply in an economy is dependent on the
state of the economy. For instance, if the economy operates below the full employment
level as is always the case, then an increase in the money supply would swiftly increase
real output levels but not the price level (Bilgili, 2001). So, increased money demand, as
a response to increased real output due to monetary expansion balances only increases
money supply and therefore leaves the price level unchanged. Therefore, Keynesians
argue that only when an economy reaches the full-employment level, then an increase in
the price level may result from monetary expansion.

Although Keynesians also do not suggest that high inflation can be generated and
sustained without rapid monetary expansion, their assertion is that other factors such as
government spending, tax cuts and supply shocks can affect aggregate demand and
aggregate supply. Inflation, therefore, cannot always be considered strictly a monetary
phenomenon as claimed by monetarists such as

Friedman (1969, 1988, 1991, 1994), Ball and Mankiw (1995), Ball (1992), Romer and
Romer (1998) and many others. The money demand theories that are based on this view
include speculative demand for money, Keynes (1936), the inventory theoretical
approaches by Baumol (1952), Tobin (1956), Tobin (1958) among others.

5.3.3. The Monetarist View

This view initially emerged from the economist Clark Warburton in the post the 2nd World
War economic writings but never gained much attention and popularity until the late
1950s following Milton Friedman works. It was however viewed as a return to the
classical theorizing especially after upholding the classical dichotomy assumption in
which there is long-run monetary neutrality in the nominal sector of the economy.
Following the classical tradition, monetarists view is that money growth is the ultimate
source of inflation (Phelps, 1967; Friedman, 1959). This view is summarized by Milton
Friedman’s famous statement that ‘‘inflation is always and everywhere a monetary
phenomenon’’ (Mishkin, 2007; Romer & Romer, 1998).

When elaborating this view on inflation and its control, Friedman stressed that
“controlling the growth of money is important because, ultimately, inflation is a monetary
phenomenon – nothing else. If you control the growth of the money supply, you control
 132

inflation; if you do not, inflation cannot be limited. Secondly, this control is important
because money is pervasive and affects the entire economy (Friedman, 1983a: 193, 200).
According to Friedman, under a stable money demand function, an optimum level of
money supply can be achieved especially when the interest rate is zero (Kia & Darrat,
2007). In short, the Monetarist school of macroeconomic theory traditionally emphasize
that if the money demand function is stable, monetary aggregates are the ultimate
determinants of price level (inflation rate) in an economy (Hossain, 2015).

Monetarists argue that monetary policy regulators cannot achieve sustainable economic
growth through policy induced aggregate demand in the economy. This is because there
is a natural rate of unemployment (NAIRU) in the long-run to which the economy always
returns when short-run business cycles and shocks are fully absorbed by the economic
agents. In short, excess demand always converges to its long-run steady state (Humphrey,
1985). Therefore, any tendency by the monetary authority to exploit short-run inflation-
unemployment trade-offs only leads to higher inflation rates in the long run. Money
demand theories developed based on this view include the modern quantity theory of
money, Friedman (1956), Sargent and Wallace (1982) extra.

5.3.4. The New classical view

This emerged during the 1970s as a critique to both the Monetarist monetary and the
Keynesian theories. This theory is built on two groups of assumptions; the rational
expectations hypothesis (REH), and the full-flexibility of all prices and wages in all
markets, and Walrasian equilibrium (Birol, 2015). The REH rejects the Monetarist view
of adaptive expectation hypothesis (AEH) in which economic agents systematically
continue to underestimate actual inflation even when announced by the policy makers.
The new classical theory asserts that economic agents are rational thinkers and therefore
able to alter their expectations concerning future inflation as they learn from the policy
makers. So, expectations are subject to what is known as the “Lucas critique” (Lucas,
1976). The full flexibility of all prices in markets and Walrasian equilibrium rejects the
Keynesian assumptions of fixed and sticky prices.

Therefore, as opposed to the Keynesian theory, the New classical theory assumes perfect
competition in both the commodity and labour markets. This implies that there would be
neither excess demand nor supply in the markets (due to the existence of efficient market
 133

equilibrium). That is, the Walrasian equilibrium postulates that markets always clear at
their natural rate of unemployment. In other words, markets possess an automatic
adjustment equilibrium mechanism and therefore policy induced measures cannot change
this rate. This implies that money is neutral and super neutral (money is neutral both in
the short run and the long run) and so inflation cannot be managed through systematic
monetary policy measures (Humphrey, 1985; Sargent, Thomas , 1975). Such policies
instead result into higher rates of inflation (Motyovszki, 2013).

The expected-augmented aggregate supply curve is fully vertical both in the short and
long run. The determinant for the money output trade-offs under this view depends on
whether the policy shock is anticipated or not. When unanticipated, policy fine tuning
produces changes in the real variables such as output and employment. On the other hand,
when anticipated based on rational expectational hypothesis, monetary policy shocks only
bring about a rise in the inflation rate (nominal changes).

5.3.5. The New Keynesian view

Although the real business cycle (RBC) theory that postulates that real demand for money
only responds to the rate of transactions or economic activities (reverse causation) proved
surprisingly successfully in predicting business cycles, their inability to replicate certain
moments of the observed data, their unrealistic assumption of perfect competition and
money neutrality all of which were at odds with the macro-economic reality, sparked off
further inquiry into inflation theories (Christiano et al., 1999). Most notably is the New
Keynesian macroeconomic theory which has since become the mainstream theory in the
contemporary conventional economics (Motyovszki, 2013).

Adopting the dynamic stochastic general equilibrium of the RBC models and the rational
expectation hypothesis of the new classical theory, but still maintaining price stickiness /
rigidities, the New Keynesian continues to argue that monetary policy is not neutral
(Clarida et al., 1999). To this theory, inflation is a positive function of future expected
inflation and the output gap. Therefore, monetary policy fine-tuning can be relatively
effective in moving the economy to its full potential level (closing the output gap) but at
a higher inflation rate due to the existence of “inflation-unemployment trade-offs”
(Romer, 1990).
 134

However, due to the rational expectational hypothesis, the economy always reverts to its
long run equilibrium state and therefore money becomes neutral in the longer term.
Therefore, monetary policy fine-tuning becomes ineffective in the long run and so central
banks ought to stick to rule-based policies to avert inflationary expectations in the
economy. Apparently, both the new classicals and the new Keynesians agree that
monetary authorities should not try to exploit the short-term trade-offs to try to push the
economy out of its supply potential levels as this will only worsen the inflation rate in an
economy in the long run.

5.3.6. The Islamic view of inflation

The Islamic view of inflation is that it can be because of both demand and supply shocks.
Since both monetary and fiscal policies influence the aggregate demand and aggregate
supply in an economy, Islam lays down strict rules and regulations for both fiscal and
monetary policies to prevent either one or both of them combined from causing a
sustainable rise in the price levels (Kia, 2014).

The philosophy behind an Islamic economic system is anchored on to the realisation of

three main goals including stability in the value of money, economic wellbeing with full
employment and optimum rate of economic growth, and social-economic justice that is
characterised by equitable distribution of income and wealth (Chapra, 1985; Es-Sadr,

1980: p.291-303). To achieve these goals Islam lays down key fundamental principles to
guide not only the proper execution of transactions but also aimed at litigating inflationary
and deflationary tendencies in the economy (Uddin, 2016).

The policy measures that have been practiced since the early days of Islam such as
prohibition of riba, prohibition of hoarding of coins as well as goods, ban on swapping
of debts with debts, prohibition of gharar and maisir related dealings, ensuring honest
and fairness, discouragement of speculative tendencies, among others, all work in a
synchronised manner to facilitate the maintenance of a stable velocity of money. Once
the stability of the velocity of money is realised, maintenance of price stability becomes
viable (Khan, 1996).

Besides, the obligation or requirement that money as well as business contracts are either
asset-based or asset-backed and the 100% reserve requirement substantially narrows
 135

down the discrepancy between the nominal and real sectors. That is, the rate of money
supply relatively relates to the level of transactions in an economy at a given time.
Therefore, in case of a monetary or financial shock or both, the Islamic financial system
adjusts relatively quicker and in a steady manner to clear the shocks in the system as
compared to the contemporary system (Khan, 1986).

More importantly, Islam guarantees low rates of inflation by emphasising four main
“built in stabilizing mechanisms” for an Islamic economy. These include replacing debt
financing by equity-based financing, encouragement of moderate consumption and
condemnation of wastefulness, emphasising the institution of zakat and mirath laws both
of which facilitate the redistribution of economic resources to the disadvantaged cohorts
of the population, and lastly declaring money as a trust by the Islamic governments
(Siddiqi, 1996). Taken together, the overall economic implication is that stability of
money value as an indispensable macro-economic goal is maintained under an Islamic
monetary system.

Following an analysis of the different monetary theories summarized above, this study
finds the Classical – Monetarist theories generally compatible with the principle of
Islamic monetary policy. However, this study has opted for a generalised money demand
function (with modifications) which has widely been applied in various empirical works
Laidler (1993: Ch.8). The justification here is that estimations from a specific money
demand theory may have limited application and may leave out some very important
specific details with wider implications. Besides making inferences based on a
generalised theory are more compelling compared to those from a specific theory.

Across the available theoretical literature, there is a consistent hypothesis that an Islamic
monetary policy is more effective in the attainment of the central bank goals compared to
the conventional capitalist policies that are based on interest rate payment and charges.
This therefore implies that ceteris paribus, countries that are moving toward the
Islamisation of their economies should have reducing levels of inflation, lowering
unemployment rates, increasing economic growth among other monetary policy goals.
The justification for this argument is that absence of interest rate in an Islamic economy
lowers the cost of production and thus improves consumption as the goods are offered at
both lower and stable general price levels. So, designing an interest-free monetary policy
 136

facilitates the attainment of the above macroeconomic goals which is the aim for every
monetary authority.

Following Selim and Hassan (2019) we postulate the fundamental theoretical foundations
for the Islamic monetary policy basing on the following equation.

; ˂ 0; ˃ 0; ˃0 (5.2)

Where, I = investment, = autonomous investment, r = nominal interest rate, QH= qard

hasan (benevolent / Interest-free loans), Y= National output and μ, , are
coefficients. The above expression asserts that there is an inverse nexus between the rate
of investment expenditure (I) in an economy and the rate of interest (r). In other words,
when the interest rate increases, the rate of investment expenditure slows down and vice
versa if the interest rate falls (Samuelson and Nordhaus, 2004:144).

Investment, therefore, is maximized at a point when the interest rate equals zero (r = 0).
The inefficiencies that have caused economic instabilities both at macro and micro
economic levels throughout history have been associated with money turn over alluded
to the inverse relationship between interest rates and investment rates (Ascarya, 2009)

The implication here is that as the rate of interest-free banking and financial operations
plus the profit and loss sharing based tools increase as the case should be under Islamic
banking and monetary system, the rate of investments keep increasing until it reaches its
maximum level. The investment rate increase is given by the following equation.

0 (5.3)

The increased investment facilitates the realization of the macroeconomic goals and
promotes greater stability in financial markets (Iqbal & Mirakhor, 2007).The equation
above implies that usury free lending system (characterized by Profit and loss sharing
plus qardh hassan loans (QH)) has a positive impact on the rate of investment (I) in an
economy. In the same way, an Islamic monetary policy (imp) which is characterized by
profit and loss sharing-based instruments and the absolute absence of interest charges
should have a positive impact on the level of investment and consequently the monetary
policy goal realization.

Substituting QH for (imp), the above equation is expressed as follows.

 137

0 (5.4)

The above equation implies that

(5.5)

To clearly grasp the above theoretical conceptualization, the relationship between

economic growths, investment, the Islamic based monetary system, and the conventional
interest-based system is expressed in the figure below.

Figure 5.1. Comparison of economic growth of the Islamic system (profit and loss
sharing) and the conventional (interest-based system)
Returns (PLS)

Interest rate
B C
E
Economic growth

D
A F

0 0 ′ ′ 0 ′ ′
Investment Investment (Deposit Investment

(A) (B) (C)

Source: Ryandono (2006).

The initial national output is represented by the area (0, G0, A, I) as in panel (a) above. In
a conventional economic system, when the desired level of national output increases from
G0 to G1, the required investment level is expected to move from to in panel (a).
However, the existence of interest rate charges limits this investment expansion rate. The
realized national output at the new interest rate therefore equals (0, , E, ) as in panel
(c), far less than the potential national output represented by area (0, G1, B, ) in panel
(a). So, the area (0, G1, B, )- (0, G1, B, ) represents unrealized potential national output
that is put to waste due to interest rate charges (Behdad, 1989; Khan and Mirakhor, 1986).

Production at excess capacity leads to wastage of scarce resources, exploitation of

consumers, perpetual poverty, predation, and intimidation in economic activities all of
 138

which are typical vices that characterize the capitalistic economies across the globe
(Yousefi et al, 2010).

Panel (b) represents the Islamic economy based on profit and loss sharing (returns) as
well as interest-free loans as postulated in the investment demand theory under the Islamic
banking literature. The actual output area (0, , D, ) which is equal to initial national
output (0, G0, A, I) as in panel (a). When the desired output increases from G0 to G1, the
investment expenditure moves from to in panel (a).

Due to the positive relationship between economic returns (πe) and the investment level,
an Islamic economy adjusts from (0, , D, ) output to the new potential national
output (0, , C, ) in panel (b). The actual and potential national output areas are the
same, that’s panel (a) and panel (b) represent exact areas (0, G0, A, I) = (0, , D, )
and (0, G1, B, )= (0, , C, ).

The equation (4) above demonstrates clearly that money supply under an Islamic
monetary policy framework and the investment rate have a positive relationship.

So, when there is an expansionary monetary policy, the investment rate increases by β
(where β ˃ 0) times the change in money supply (Selim and Hassan, 2019). The real
output equilibrium level shifts due to the upward movement in the aggregate expenditure
function. The increased investment further increases national output to a new real Gross
Domestic product equilibrium from Y* to Y1 through the principle of multiplier-
accelerator. This is illustrated in the aggregate expenditure graph below.
 139

Figure 5.2. The effects of expansionary monetary policy on real GDP under the interest-
free monetary system
AY=Y
B AE

Aggregate

AE

A
C

GDP

GDP (Income)
(Equilibrium GDP)
(Potential new equilibrium

Source: Created by the researcher.

As noted earlier, in general terms, the Islamic economic framework is not totally alien to
the conventional system, especially the classical macroeconomic theory (Hussain, 2009).
Because they were learned or copied from the robust economic teachings of Islam, the
early classical teachings by Adam Smith (the believed further of modern classical school
of macroeconomic theory) emphasised the divine, ethical, and moral virtues that are
espoused by Islam. In fact, many conventional economic practices resembled those of
Islam until they started to gradually change to their current state (Çizakça, 2006;
Udovitch, 1981; Walsh, 2006).

The investment expenditure function of equation (1) demonstrated that increased

investment because of lower cost of capital in an Islamic economic environment will
further increase the output level by γ times the change in Y.

where; ˃0 .

0 (5.6)

Implying that; (5.7)

 140

Similarly, the absence of interest rate charges positively impacts on the aggregate
consumption and aggregate government expenditures in an Islamic based monetary
system. As the debate rages on whether the development of Islamic banking and finance
should begin from scratch or simply take an Islamisation process of the existing theories,
an examination of the interest-free monetary policy framework and its impact on the
consumption function as well as on major macroeconomic objectives in this study
considers the latter over the former.

The absolute income hypothesis developed by Keynesians postulates that consumption

expenditure, C, depends positively on the disposable income, Yd, and negatively on the
interest rate. The disposable income and 0 . Since loans are
based on no interest charges, the relationship between consumption and loans offered is
positive. The above theorizing is summarized in the following equation.

; ; (5.8)

– ; ; 0 . ˂ 0; ˃0 (5.9)

Where consumption expenditure, = autonomous consumption,

disposable income given by ( ), Y= output (income), T= Tax, ( ),
autonomous taxation , , Z = Zakat (whose ratio, 2.5% times the
income (zY) , nominal interest rate. In equation (5.8) above, the Islamic economy
ensures that the government maintains its fiscal discipline through handling public
resources as a trustee from Allah for which government officials shall account in the
hereafter life (Chapra, 1996).

According to Ausaf (1985) and Metwally (1981), consumption in an Islamic environment

cannot be modelled without considering the impact of the institution of zakat to both its
givers and receivers. This consideration, however, is not the focus for this study. In this
case therefore, the need for extra taxation after zakat payment is considered very minimal
or even absent (Salim and Hassan, 2019). So, less taxation implies that there is greater
multiplier effect in incomes because of the institution of zakat that redistributed wealth to
the bigger cohorts of the population, creates a high aggregate demand and expenditure,
creates further employment opportunities, among others.
 141

In equation (5.9), where there are both zakat charges as well as autonomous and income
taxes as the case is in dual finance environments, the multiplier effect is highly hampered
thereby hindering the rate of economic growth.

The relationship between consumption expenditure and the Islamic monetary system, the
interest rate in the above equation is replaced by an interest-free monetary policy tool or
system (IFMP). The equation thus becomes.

– ; ˃0 (5.10)

The implication of the above function is that consumption expenditure in an interest-free

environment varies directly with the extent of expansion of the Islamic monetary policy.
Precisely, the following equations sum it up.

0 (5.10)

This implies that the change in consumption expenditure is a function of the Islamic
monetary policy (imp). Therefore, as the Islamic monetary policy practices of a country
expand, consumption is expected to continue expanding along. Therefore, the rate of
change of consumption behaviour is expressed as follows.

(5.11)

The positive relationship between interest-free based monetary and financing policies
(ifmp) and consumption (C) bring about increased consumption from C0 to C1 as earlier
noted (on the aggregate expenditure graph. This positive consumption is substantiated
through the Islamic social institutions such as zakat, infaq, sadaqah, and waqf (Mirakhor
and Iqbal, 2012). Therefore, ceteris paribus, all this work to increase aggregate
expenditure thereby prompting a shift in the aggregate expenditure function upwards,
causing a reduction in unemployment rates and ultimately achieving a new higher
equilibrium real GDP (Y1). The Interest free monetary policy operation work through
their impact on consumption expenditure to expedite the attainment of the monetary goals
(Selim and Hassan, 2019).

Similarly, the Government expenditure function in an Islamic monetary policy

environment can be developed as follows.
 142

; Where, ˃0 (5.12)

In an Islamic monetary environment, government expenditure increases and so is the

public investments because of interest-free loans. This is contrary to the conventional
economic system where increased government expenditure “crowds out” private
investment. This reduces the extent of economic growth as private investment falls. This
implies that interest-based financing systems limit the full employment extent of capital
(Ahmed, 1994). The following illustration summarizes this effect on the real GDP of the
economy.

Figure 5.3. An illustration of how government expenditure crowds out private

investment and reduces aggregate output under the interest-based financial system
( )
Aggregate Expenditure

45

Investmen

Source: Researcher’s own illustration.

From the above figure, a lower equilibrium point ( ) characterised by low consumption
rate, low investment and Government expenditures and Lower GDP ( at the given
interest rate level. When Government increases its expenditure, the result impact a shift
in the equilibrium, point from the ( ) with a lower income level to ( ) with a higher
income ( ). To mitigate inflation tendencies that are associated with increased demand
in the economy, the central bank adjusts its policy rate to a higher level which renders the
cost of borrowing higher as financial institutions hike their interest rates. This makes the
cost of borrowing very high, lowers investment expenditure, lowers household
 143

consumption expenditures and therefore the equilibrium point shifts towards a lower
point ( ) where GDP level is only ( ). So, interest charges crowd out the full impact of
increased government expenditure in an economy.

Under the Islamic system, the absence of interest rates on governmental investment loans
fosters infrastructural development without compromising the private sector investment
initiatives. It should be noted though that government investment per se is irresponsive
of the rate of expected returns in the business sense. However, interest-free loans for
infrastructural development plus the stream of social funds such as sadaqah, zakat, infaq
and waqf that are equally offered with no expectation of material profits here on earth,
enables the societal aggregate expenditure function to shift upwards until it reaches the
optimal equilibrium point.

Besides, monetary policy is linked to the development policy although the central bank
ultimate object is to ensure price and financial stability. So, ceteris paribus, under an
Islamic monetary system, optimal economic growth is maintained as illustrated below.

Figure 5.4. An illustration of how government expenditure facilitates private investment

and increases aggregate output to optimum level under the interest-free financial system
(C+I+G)
Aggregate Expenditure

0 Investment

Source: Reseacher’s own illustration.

 144

As already pointed out earlier, the absence of interest rate charges, existence of lower tax
charges coupled with the wealth redistributing mechanisms of social institutions such as
zakat and Sadaqat implies that an increase in government expenditure increases
consumption, and investment expenditure thereby prompting a shift in the equilibrium
points from ) to ). Therefore, ceteris paribus, when fully developed, an Islamic
financial and monetary system with all its safety nets operates at the optimal level of
economic growth as illustrated in the following figure.

Figure 5.5. An illustration of the optimal point at which the Islamic financial and
monetary system operates

Profit and loss Economic growth

IS ID

X ∗ Y

0 0 ∗ Investment
Investment

Source: Ryandono (2006) and Sakti (2007). * = optimal point.

The (*) script signifies that the economy operates at its optimal level at that point. This is
because, under the Islamic monetary system, stability is considered not just a target to be
pursued but a prerequisite for the effective use of monetary policy instruments (Uddin,
2016; Chapra, 1996; Al Jarhi, 1983).

From the above discussion, it becomes clear that the effect of government expenditure
under an Islamic monetary policy is positive. The following equation summarises this
assertion.

0 (5.13)

This implies that; (5.14)

 145

The above two equations imply that as an economy expands its monetary operations in
line with Islamic teachings, aggregate expenditure by government keep increasing,
investment increase, employment opportunities increase and ultimately the real GDP
equilibrium point moves to a new higher point following the upward shift in the aggregate
expenditure function. Based on the above elucidations, monetary policy goals are
achieved more effectively under the Islamic monetary compared to the conventional
system.

5.4. Conclusion

In conclusion, all the above theoretical formulations clearly demonstrate the superiority
and relative effectiveness of the interest-free financial and monetary system over interest-
based system. The next chapter empirically assesses this postulation further through
comparing the stability of the money demand function (MDFs) under both systems in the
context of selected Muslim majority countries. The next section thus focuses on the
methodology and empirical estimations aimed at augmenting the above hypotheses.
 146

CHAPTER SIX
METHODOLOGY, EMPIRICAL ESTIMATIONS, ANALYSIS,
DISCUSSION AND RECOMMENDATIONS

6.1. Introduction

This section empirically examines the relative stability of the money demand function in
dual monetary economies in respect to the Muslim majority countries under study.
Whereas there is a clear prohibition of interest-based business and financial transactions
in an Islamic economic system, interest rate forms the back born with which the
conventional monetary system is run. So, to assess the superiority and effectiveness of
the Islamic monetary system over its conventional counterpart, the relative stability of the
interest-free real money balances (IFMP) versus interest-based real money balances
(IBMP) in eight Muslim majority countries over a period extending from 1991-2016 is
conducted. Based on the results obtained, the monetary policy implications of the money
demand functions under the two systems are discussed.

6.2. Data Variables and their sources

The analysis of this study is based on an annual panel data from eight Muslim majority
countries that are considered leading in the implementation of Islamic banking and
finance (Ernst and Young, 2015). These include Saudi Arabia (31.70%), Malaysia
(16.70%), Kuwait (10.50%), Qatar (7.70%), Turkey (5.80%), Indonesia (3.80%), Bahrain
(1.70%), and Pakistan (1.20%). This data, secondary in nature, was collected from the
International Monetary Fund (IMF) -International financial statistics (IFS), the websites
of the monetary authorities of the above countries and World Bank. These were
categorised as leading in the implementation of Islamic banking and finance by Ernst &
Young (2015). The study data spans from 1991-2016 that makes a total of 26 for eight
cross-sections.
 147

The unavailability of variable series for some of the countries for a long period justified
our choice for a panel data format. Besides, panel datasets take care of both cross-section
and time dimensions of the data and therefore provides detailed information concerning
the data variables. Also, panel data estimation results have been found and hailed as more
efficient compared to time series because of several reasons; the less likelihood for the
occurrence of multi-collinearity between and or among the different variables, offering
of greater variability of the data and higher degrees of freedom, among other reasons.

6.3. The basic money demand function

As mentioned in chapter five, a great deal of the existing monetary literature stress that a
properly specified demand for money function plays a very vital role for monetary policy
operations (Gerlach and Svensson, 2004; Siklos and Barton, 2001). In fact, many of the
macroeconomic theories consider money demand and its determining factors not only as
a very crucial component for the effective implementation of monetary policy but also a
critical building block for the theories themselves (Goldfeld, 1994). Through this
function, the monetary authorities can link money supply to the real sector of the economy
with a goal to stabilize both prices and the financial system. The central bank can forecast
the changes in the output gap and thus regulate the money supply at a rate that facilitates
relative monetary stability (Özturk and Acaravcı, 2008).

As seen in the previous chapter, the traditional basic functional relationship for the
demand for money is generally specified in such a way that the real money balances is a
function of two main categories of variables, a scale variable, and an opportunity cost
variable. For example, the Keynesian money demand function which forms the
centrepiece for the mainstream conventional monetary literature is presented in the
Keynesian liquidity preference function as follows:

, (6.1)

Where M is the nominal money which represents a specified monetary aggregate and P
is the price level in the economy. (M/P) is the real money balances as a function of some
chosen scale variables that include (Y) as a measure for the transacted activities
(economic activities) and the (i) representing the opportunity cost variable for holding
money. Originally, the demand for money was considered proportional to the nominal
 148

income (Y) until the time when Keynes added speculative motive as a third motive for
money demand. This addition laid the foundation stone for the introduction of interest
rate in the money demand function (MDF). Whereas permanent income hypothesis as
developed by Friedman (1956) was considered appropriate and usually used as a scale
variable in many developed economies, the same was not true for the least developed
countries until the 1970s.

Since the 1970s, however, there has been an evidently increasing consensus among
researchers to consider permanent income as a substitute to measured income in the
developing economies (Hassan, 1992; Khan, 1980; Laumas and Laumas, 1976). Much as
we recognise the superiority of wealth over real GDP as a scale variable in producing
better stability in the money demand function as found by different studies including
Laidler (1997), Chow (1966), and Meltzer (1963), we could not employ it due to
measurement challenges that come along with choosing it as a scale variable.

To estimate the co-integrating vector, we applied three different methods: panel FMOLS,
panel DOLS and ARDL model. While the panel FMOLS and DOLS focuses on the
demand function (MDF) for both the panel and individual cross-sections on the long-run,
the ARDL model estimates both the short-run and the long-run co-integrating vectors for
each of the eight individual cross-section and tests for the relative stability of money
demand models under the two monetary systems. The details and advantages for each of
the three methods are explained briefly in the sub-section that follows.

6.4. The demand for money and panel DOLS and FMOLS approaches

As the case is in most of the studies on money demand, the variable data is transformed
into logarithms to facilitate interpretations except the expected inflation rate since its
series are presented in percentage form. Taking all the above discussion in mind, the
standard demand function assumes that the demand for money in an economy is a
function of mainly two categories of explanatory variables as already pointed out; (i) a
scale variable (real income (GDP)) and (ii) variables that represent the opportunity cost
for holding money including the interest rate variable and inflation rate.

Since the speculative motive of holding money is highly minimised and even expected to
completely disappear as economies fully embrace Islamic economic teachings and
 149

methodologies of doing business as pointed out by Chapra (1996), the prohibited interest
rate has no room in a money demand function (MDF) in an Islamic economy. Whereas
speculative motive is quite rampant in the conventional monetary system, we assumed it
absent to simplify our estimations following equation (5.7), which is an augmented
version of equation (5.6), the money demand function for our study is expressed in the
following form.

M/P f GDP , π , EX , ε (6.2)

Where; the real demand for money balances, GDP the real income (as a scale

variable to measure economic activities), π expected inflation rate (as a vector of

opportunity costs) and EX = real expected exchange rate as another variable that affects
the money demand in an open economy, and the error term. However, across
monetary economics literature, the money demand function is estimated in a log-linear
form if no percentage-based variables are included in the modelling. Therefore, apart
from the expected inflation rate, which is in percentage form, the rest of the variables and
the monetary aggregates are all in logarithms. The money demand functions thus assume
a semi-logged character following the general monetary theory consensus whose origins
date back to mid-1950 (Cagan, 1956; Zarembka, 1968; Aghelvi, et al., 1979).

L IFMP , a bLGDP , cINFLNEX , dLEX , ε, (6.3)

IBMP , a bLGDP , cINFLNEX , dLEX , ε , (6.4)

Where; L IFMP , the log of panel monetary aggregate M1 (comprising of demand

deposits + currency of commercial banks) as proxy for the Islamic monetary policy
aggregate, L IBMP , the log of monetary aggregate M2 (comprising of (time deposit
+ savings of commercial banks) as proxy for the interest-based monetary policy
aggregate, LGDP , log of the panel real GDP, INFLNEX , panel expected inflation
rate, LEX , panel real expected exchange rate and ε , the error term with white noise
and zero mean. While a and a = constants for models one and two, respectively,
, c and d represent coefficients.

In this study, a panel of eight countries with dual-finance systems was built for the
selected Muslim majority countries, considered leading in the implementation of Islamic
 150

banking and finance following Earnst & Yung (2015). Macroeconomic data is associated
with endogeneity and contemporaneous relationships that result into serial correlation and
spurious regressions. Also, once the error terms are serially correlated, the Ordinary Least
Squares (OLS) estimators may be led to depend on nuisance parameters that produce
spurious regression results and wrong inferences.

The applied empirical methodologies to estimate the long-run money demand relations44
in this study are the Phillips and Hansen (1990) advanced co-integration panel Fully
Modified Ordinary Least Squares (FMOLS) and the Mark and Suk (1999, 2003) Dynamic
Ordinary Least Squares (DOLS) estimators (Phillips and Moon, 1999; Pedroni, 2000,
2001; Kao and Chiang, 2000). These two approaches are recommended when the panel
data possesses contemporaneous correlation among some of or all the units of the cross-
section set. The two methodologies combine non-parametric approaches and white
heteroskedastic standard error terms to produces robust estimates (Arize, et al., 2015;
Osang and Slottje, 2000).

The main advantage of the above two panel estimators lies in their ability to correct the
long-run correlation problems among cointegrating equations as well as among stochastic
regressors. Besides, while the FMOLS estimator produces robust results that are
asymptotically unbiased, the DOLS estimator eliminates feedback in the co-integrating
regression by including leads and lags of the explanatory variables which clears long-run
dependence problems, thereby producing asymptotically efficient results (Saikkonen,
1992; Stock & Watson, 1993; Dreger et al., 2007; Carlsson et al., 2007).

According to Wagner and Hlouskova (2010), even in the presence of endogenous

regressors, DOLS and FMOLS estimators are hailed for producing unbiased estimates for
cointegrated variables. Besides, under cointegration, the DOLS estimator is super-
consistent and especially robust not only to the omission of variables that do not form
part of the cointegrating relationship such as interest rate, Harris and Sollis (2003) but
also reducing the bias of small sample size (Masih & Masih 1996). Considering the two
panel estimators together produces robust results with appropriate inferential statistics.
This justifies our choice for the long-run panel estimators.

44
The long-run relations among money, output, prices, and the exchange rate follow the classical
monetary theory (Hossain, 2019).
 151

Therefore, by extending the Phillips and Hansen (1990) FMOLS estimators to panel data
sets, Phillips, and Moon (1999), Pedroni (2000), and Kao and Chiang (2000) developed
three categories of the FMOLS estimator that include Pooled estimator, Pooled-weighted
estimator, and the Grouped estimator all of which are considered in this study.

Also, by simulating Monte Carlo, Pedroni (2004) demonstrated that with small size
properties, consistently, the un-weighted statistics perform better than the weighted ones.
The asymptotic properties of the various estimators are compared based on pooled data
along the “within” and “between” group dimensions such as FMOLS, DOLS, and OLS
estimators of the panel. Even group mean estimators of the FMOLS type in considerably
smaller samples exhibit higher performance powers if the time under consideration is
higher than the number of cross-section in the study (Pedroni, 2000). Whereas FMOLS
is a non-parametric model of solving the serial correlation problems, both OLS and DOLS
are parametric approaches in which DOLS estimators are combined with lagged first-
differenced terms. The panel regression models for these parameters are expressed as
follows:

The general model for these parameters takes the form below.

(6.5)

Where; = allowance for country specific fixed effects, β = a cointegration vector

When; , 1 (6.5.1)

= a stationary vector error process in which

, (6.5.2)

The standard panel OLS estimator for the coefficient is stated as below.

^ ∗ ∗ ∗
, ∑ ∑ ∑ ∑ (6.6)

Where; i = cross-section data and is the number of cross-sections, t = times series data
^
and T is the total number of times series data, , = a standard panel OLS estimator,
∗ ∗
= exogeneous variable in the model, , = endogeneous
∗
variable in the model and is its mean.
 152

Paying attention to endogeneity and serial correlation problems in the model, Pedroni
(2000) proposed the group-mean under a fully modified OLS estimator in which Phillips
and Hanseri (1990) semi-parametric correction to OLS estimators are fully incorporated.
This incorporation helps the estimators to adjust for any form of heterogeneous property
that may be present in the underlying dependent and or independent variables in the
model. The proposed FMOLS statistic model is constructed as follows.

^ ∗ ∗ ^
, ∑ ∑ – ∑ – (6.7)

Where; i = cross-section data and is the number of cross-sections, t = times series data
^
and T is the total number of times series data, , a standard panel FMOLS
∗
estimator, = exogeneous variable in the model and , =
∗ ∗ ∗
endogeneous variable in the model and . ῼ^ /
ῼ^ ∆ ; ῼ^ represents covariance, ki represents the general panel OLS
^
statistic. represents a correction for the effect of serial correlation as a result of
existence of heterogeneous features in the short-run process determining predictor and
independent variables.

Finally, Pedroni (2001) constructed a between-dimension and group-means panel DOLS

estimators contrary to the non-parametric FMOLS estimators discussed above. The
argument here is that the t-statistics in this case offers more flexible alternative hypotheses
compared to the “with-in” dimension. This is because, both the between-dimension and
the group-means incorporate corrections for endogeneity and serial correlation in a
parametrical manner.

This is modelled as follows.

∑ ∆ , (6.8)

Where; i = cross-section data and N is the number of cross-sections, t = times series data
^
and T is the total number of times series data, , a standard panel DOLS
∗ ∗ ∗ ∗
estimator, 2 1 1, , = the mean value of and
∆ , = the differential term of X
 153

6.5. The Demand for money and the ARDL approach

As pointed out earlier, this study also applies an Autoregressive Distributed Lag approach
to cointegration aimed at specifically regressing the short-term estimations (Perasan and
Shin, 1995; Perasan, Shin, & Smith, 1996; Perasan and Shin, 1999). According to Engle
and Granger (1987), when two or more variables are cointegrated, the possibility for the
estimated co-integration relationship among them being spurious is ruled out. Engle-
Granger test (1987), Johansen test (1998) and Phillips and Hansen test (1998) are among
the several co-integration methodologies that have for long predominated the economic
literature since the late 1980s.

However, unlike, the ARDL approach, all the above techniques strictly rely on the
requirement that all variables are stationary of one specified level. This makes estimated
results from such cointegration tests subject to biases at the minimum and spurious at
worst. To avoid such biases and spuriousness in the results, this study adopts the ARDL
to co-integration approach for the individual members of the cross-section.

The generalised form of the ARDL (p, q, q…q) model is specified as below.

∑ , ∑ , (6.9)

Where is the dependent variable, is a k x1 vector which can be purely I(0) or I(1)
or co-integrated but never of I(2). is the coefficient of the lagged dependent variable;
are 1 coefficient vector; is the unit specific fixed effect; i = 1, …, N; t =1,2, …,
T; p,q are optimal lag orders; is the error term.

The re-parameterised ARDL (p, q, q,…q) error correction model is specified as follows;

∆ , – , ∑ ∆ , ∑ ∆ , (6.10)

Where; ∆ denotes change; = -(1- ), group-specific speed of adjustment coefficient

and the expectation is that 0 ; vector for the long-run relationship of
the explanatory variables with dependent variable; , , the Error Correction
Term (ECT) and , are the short-run dynamic coefficients. While the subscript i

represents country, t stands for time.

 154

When the above ARDL model is applied in the context of this study’s variables, the stated
money demand function (MDF) takes the following formats for both categories of the
monetary system.

∆ ∑ ∆ ∑ ∆

∑ ∆ ∑ ∆ (6.11)

∆ ∑ ∆ ∑ ∆

∑ ∆ ∑ ∆ (6.12)

Where IFMP interest-free monetary policy aggregate, IFMP lagged variable of

the dependent variable, = Interest-based monetary policy aggregate, IBMP
lagged variable of the dependent variable, GDP = Gross domestic product (real
income) inf= Expected inflation rate, real expected exchange rate, a = coefficients
and error term which is white noise with zero mean. The subscript ∆ indicate the
short-term period. In the formulation of the money demand function, the superiority of an
ARDL cointegration technique lies on the fact that it considers both stationary and non-
stationary variables in the model such as the inflation and GDP, respectively. Moreover,
unlike other standard cointegration tests that require all variables to be at the same level
as pointed earlier, the autoregressive distributed lag approach avoids this and examines
the short run and long-run relationships irrespective of whether the underlying variables
are purely I(0), or purely I(1), or a combination of both but with strictly no I(2) (Pesaran
et al., 1996, 2001).

Also, the ARDL model provides decisive interpretation of results based on the tabulated
two sets of appropriate critical values (Pesaran et al., 1996). The first set assumes that all
variables are of integration order I (0) while another assumes that they are all of I (1)
order. This classification provides a band that covers all possibilities of variable
integration from I (0), I(1) and even when the variables are fractionally integrated. Further
still, compared to Engle-Granger and the GLS-based cointegration test techniques, the F-
statistic test of the ARDL approach possesses greater power.

Under this set up, the null hypothesis of no cointegration defined as; :
= 0 is tested against the alternative that there is cointegration defined as; :
0 by the means of familiar F-statistic test. The null hypothesis is rejected if
 155

the calculated F-statistics lies above the upper bound level of the band, indicating the
existence of co-integration. On the other hand, the null hypothesis cannot be rejected if
the calculated F-statistics falls below the lower bound level of the band. However, the
results are considered inconclusive if the calculated value of the F-statistics falls within
the range of the band (Akinlo, 2006).

Once cointegration is established, we shift back to the two equations and estimate each
model using appropriate lag selection criteria including Akaike Information Criterion
(AIC) and Schwarz Information Criterion (SIC). The inclusion of more than one criterion
is aimed at choosing the most appropriate lag selection criterion to identify the true
underlying dynamics of the model.

After the estimates of the model are obtained, the CUSUM and CUSUM square tests are
applied to the residuals of the equation to test for the relative stability each model by
examining both the long-run elasticity and the short-run dynamics (Brown et al., 1975).
Before proceeding with the descriptive statistics of the study variables, an over the
variables needs to be clearly understood and this is what the following subsection is all
about.

6.6. Variable description

Both our models consist of four variable including each including M1/P ( real money
balances as dependent variable), real GDP, expected inflation rate and the real expected
exchange rate for the first model as the independent variables, whereby M1 is proxy for
interest-free money (IFM) and M2/P ( real money balances as dependent variables), real
GDP, expected inflation rate, and real expected exchange rate as independent variables,
whereby M2 is the proxy for interest-based money (IBMP are independent variables for
models one and two, respectively. We built each model basing on specific theoretical
functions of money underlying the monetary system it represents; transaction approach
and financial asset approach for the Islamic and the conventional monetary systems
respectively (Sriram, 1999).

Under the interest-free monetary model approach represented by M1, money is demanded
for settling economic activities or transactions as stressed by the classical economic view.
In this case both households’ and firms’ decisions to allocate their portfolios are reached
 156

by way of comparing between the marginal benefits of liquid money over its opportunity
cost such as interest and or inflation rate. Since interest is strictly prohibited in Islam,
interest is dropped from our model and substituted by the expected inflation rate (inflation
tax).

On the other hand, the financial asset approach which is based on the consumer demand
theory under the assumptions that households and firm owners alike, all derive their
satisfaction by acquiring and holding onto financial assets such as bonds and stocks. In
this approach, money is treated not only as a medium of exchange for which transactions
are settled but also as a real asset that earns an income (interest income or profits and
dividends earned from shares) on its own. Therefore, the total quantity of money
demanded by the economy is determined by solving for the optimal portfolio allocation
(Harb, 2004).

Independent variables are similar for both the models and they include real GDP as a
scale variable, expected inflation which is the opportunity cost variable and the real
effective exchange rate as a control variable for the eight countries in the panel for the
study period (Darrat and Mutawa, 1996). More specifically, each variable is defined in
the following section.

6.7. Dependent Variables

We employed two models where one represents the interest-free and the other interest-
based monetary system. Accordingly, we have one dependent variable for each model as
explained below.

6.7.1. M1 (IFMP)

M1 is defined in the narrow sense as a measure of the money supply that comprises of
physical currency and demand deposits. This study adopts and specifies M as narrow
money, M1 (Demand deposits + Currency) of commercial banks as proxy for the interest-
free money (IFM) under the Islamic monetary system, Hassan (1998). Therefore, it
strictly excludes financial assets that earn interest such as savings accounts and bonds. To
get the real money balances in the model, the consumer price index (CPI) is used to deflate
the monetary aggregates; thus M1/CPI.
 157

Unlike the broad money, time deposits (M2) that earn interest for their specified periods,
narrow money (M1) are generally interest-free particularly in developing countries,
Muslim majority countries inclusive. This justifies the choice for this monetary aggregate
as monetary policy representative for the conventional. Many studies such as (Skrabic
and Tomic-Plazibat, 2009, Payne, 2003), recommend that economies with
underdeveloped financial systems ought to use the narrow money aggregate (M1) in their
estimations of the money demand. This is because M1 is considered a relatively good
measure of an economy’s liquidity level constituted by the financial assets that dominate
transactions in such countries since monetary authorities can control M1 aggregate more
accurately relative to the broader monetary aggregates such as M2 and M3 Dobnik
(2011), Bruggeman (2000) among other advantages.

5.7.2. M2 (IBMP)

M2 is defined as a measure of the broad money supply that includes currency, demand
deposits, and easily convertible near money. The study employs M2 (time deposit +
savings) of commercial banks as proxy for interest-based money (IBM) under the
conventional monetary system. Specifically, it is the proxy aggregate for the conventional
interest based monetary policy (IBMP). M2 is a critical monetary aggregate that is closely
watched as an indicator of a country’s money supply, future inflation, and a key target of
central bank monetary policy in many economies including the United States of America.
To get the real money balances in in the model, the consumer price index (CPI) is used
to deflate the monetary aggregates; thus M2/CPI.

Each of the above two aggregates has enormously been hailed as good measure with
which to evaluate monetary policy impact on macroeconomic variables in the long run
although the broader money aggregate (time deposits) has had more preference (Hafer &
Jansen, 1991; Laidler, 1993). Most importantly, however, the two aggregates are
employed continuously by professionals as monetary policy measures in monetary
literature. This justifies the choice for using these two aggregates for the respective
monetary systems.
 158

6.8. Independent Variables

Both models employed the same regressor variables. These include the scale variable, the
opportunity cost variable and one extra control variable. These are explained as follows.

6.8.1. Real gross domestic product (GDP).

GDP is defined as the measure of a country’s total monetary value of goods and services
produced over a specified period, usually a year. Real GDP is a measure of a country’s
GDP that has been adjusted for inflation over a specified period. As mentioned earlier, it
is the scale variable that measures the economic activities in the economy.

6.8.2. Expected inflation rate

Inflation is defined as the persistent general rise in the price level in an economy over a
given period, usually a year. Sustained increase in the general price level reflects a fall in
a country’s purchasing power parity and so has wider implications for the monetary policy
authorities. On the assumption that these countries are aiming at adopting full-fledged
Islamic monetary and financial systems, this study uses inflation as the opportunity cost
variable in the models instead of interest rate which is strictly prohibited under the Islamic
economic order. Over and above its being prohibited, there are quite a range of other
justifications for using expected inflation rate. Inflation changes present major
implications for any economy because it influences the level of employment, investment,
trade balances among other macroeconomic variables. Also, it influences the amount of
money stock demanded in an economy. In many dual banking systems, interest rate is
included in the money demand function to measure the associated opportunity cost of
holding financial assets while that of holding real assets is captured by the inclusion of
inflation rate (Bahmani-Oskooee & Karacal, 2006).

However, due to the relatively thin and highly controlled money and financial markets in
developing countries, asset holders’ choices are mostly limited to money and goods in
such economies as opposed to money and financial assets in developed countries (Hassan,
1998). Based on such financial asset constraints, interest rate is not considered a true
representative of the opportunity cost of holding money by some scholars (Wong, 1977;
Arize et al,1999; Darrat, 1984,1986; and Hassan, 1992). Also, several studies have found
interest rate empirically non-significant in money demand functions of economies where
 159

Muslims constitute the biggest percentage of the population (Khatib and Towaijari,
1999). Most importantly however, some empirical evidence stresses the significance of
the inflation rate by asserting that a money demand function in which the inflation rate is
omitted is likely to produce spurious results (Baba et al.,1992).

As the case is with the rest of developing economies, banking, and financial clientele in
Muslim majority countries under study lack adequate alternative financial assets except
bank deposits and bonds whose interest rates are generally set and controlled by the
monetary authorities. Such strict and managed financial controls imply that there are little
and at times no variations made in these administered rates over time. This further
demonstrates interest rate as a very ineffective policy instrument as a measure of
opportunity cost for asset holders (Qin et al., 2005).

Furthermore, some studies that have encountered multi-collinearity problems in their

money demand function estimations have attributed it to the inclusion of both interest and
inflation rates in their models (Payne, 2003). Subsequent studies altogether excluded
domestic interest rate in the money demand function on ground that interest rates are
arbitrarily set by the money regulatory authorities (Mehrotra, 2008). More intriguingly,
interest rate as a price of credit, not money, should not be included in any money demand
modelling. Otherwise, the estimations and eventual inferences made from such
regressions ought to be misleading in the general sense considering the relationship
between money and interest rate (Woodford, 2005).

The argument here is that various studies have stressed that traditional arguments of
money demand being a function of interest rate as not compelling at all. For example,
Cochrane (2011), Bauer and Rudebusch (2011) all question the quantitative easing
actions taken by the Federal open market committee (FOMC) on interest rates in the
United States of America. Other studies that find the traditional argument on the necessity
of interest rate in monetary policy regressions as being exaggerated include (Laidler,
1993; Thornton, 1995; Friedman, 1999; McCloskey, 2000; Fama, 2012). In most cases,
fluctuations in interest rates interact w ith inflation through both import output expenses
and expectations of the economic agents. For this reason, interest rate transivity
negatively affects the success of monetary policy applications (Özatay, 2011, p. 233).
 160

So, increasingly, the expected inflation (INFLNEX), not interest rate is gaining general
acceptability as the most appropriate measure for the opportunity cost of holding money
in developing countries (Bahmani, Oskooee and Tanku, 2006; Budina et al., 2006). Other
studies in which the use of inflation rate was preferred to interest rates as the most suitable
appropriate measure of opportunity cost in the money demand function include Bahmani
and Kutan (2009); Chen (1997); and Ghatak (1995, p. 26) among others.

Most developing countries are generally very reluctant to frequently publish inflation data
for fear of political retribution that is associated with high inflation tendencies, a common
occurrence in nearly all developing economies. As a result, many studies that require
inflation data employ changes in consumer price index (CPI) as a proxy for inflation and
this study is no exceptional.

6.8.3. Real effective exchange rate (REER)

The real effective exchange rate refers to the weighted average of a nation's currency in
relation to an index or basket of other major currencies such as the US dollar, Euro,
Pound, extra. By comparing the trade balances of a country's currency against each
country within the index/basket, the relative weights of a country in question can be
determined. Considering the globalised nature of modern economies today, wealth
holders include a combination of both domestic and foreign assets in their portfolios.

Therefore, a money demand function specification may not be adequate to explain the
money demand behaviour when the real effective exchange rate is excluded in the money
(Hossain, 2019); Arango and Nadiri, 1981; Bahmani-Oskooee and Pourheydarian, 1990;
and Mundell, 1963). The exclusion of real effective exchange rate in some of the existing
panel studies in the money demand function such as Nautz and Rondorf (2010), Kumar
et al. 2010 among others has created biases to the conclusions inferred from such studies.
This is because, as economies become more open, exchange rate assumes a significant
role in the money demand equation (Harb, 2003).

During periods of high inflation (hyperinflation), to restore the value of the national
currency, monetary authorities normally on a partial basis, replace the domestic currency
with the foreign currency like the US dollar during periods of hyperinflation. This justifies
 161

the inclusion of real effective exchange rate in the estimations of any money demand
equation.

The expected signs for the explanatory variables in both the interest-free and interest-
based estimations are as follows; the GDP and the lagged variable of the independent
variable both have positive signs, implying a positive correlation with the dependent
variable, while the expected inflation may have both negative and positive elasticity
correlation with the dependent variable. The negative expected inflation rate coefficient
implies that the opportunity cost of holding money as a motive plays a relatively minor
role compared to the transaction motive (Komárek аnd Melecký, 2001). More,
importantly, the negative effect of inflation on the general performance of the economy
has been documented in various studies including (Dreger and Wolters, 2009; Mehrotra
2008; Hossain, 2007). For example, very high expected rate of inflation may decrease M1
because of decreased level demand deposits. Similarly, increased expected inflation rate
may decrease M2 because of decreased saving levels and interest income earnings. The
positive sign implies that increase in expected inflation rate re-enforces the money
demand for real money balances as currency loses its purchasing power value Therefore,
this study expects similar sign for the inflation coefficient value.

Similarly, for the real effective exchange rate, the signs may be equally ambiguous in that
this variable can have a positive sign and or a negative sign depending on the performance
of the economy and the expectations of the economic agents. For example, according to
the currency-substitution effect approach postulated by Calvo and Rodriguez (1997), the
coefficient of the real exchange rate carries a negative sign because the foreign currency
demand increases as the economic agents lose confidence in their national currency
following a depreciation. So, if nationals expect the domestic currency to depreciate
further, their demand for it decrease further via a substitution-effect with a strong foreign
currency like the US dollar.

On the other hand, depreciation lowers the price of the domestic currency in relation to
the foreign currencies. The cheaper domestic goods induce increased demand from
abroad, increased domestic investment and production, increased transactions as a
consequential need for more money to hedge against inflation tendencies (Komárek and
Melecký, 2001). In this case, the coefficient of the exchange rate in the money demand
 162

function carries a positive sign, which implies a positive correlation with monetary
aggregate in question.

6.9. Descriptive statistics of the data variables

Our sample initially consisted of the nine Muslim majority countries with the leading
Islamic banking and finance shares. These consists of; Saudi Arabia (31.70%), Malaysia
(16.70%), United Arab Emirates 14.60%, Kuwait (10.50%), Qatar (7.70%), Turkey
(5.80%), Indonesia (3.80%), Bahrain (1.70%), and Pakistan (1.20%) that were
categorised as leading in the implementation of Islamic banking and finance by Ernst &
Young (2015). However, United Arab Emirates was dropped from the sample because of
missing some data series for some variables, and so only eight countries were considered.
The data used spans for the period from 1991-2016. Due to unavailability of some
important monetary data series in these countries, appropriate proxies are used to answer
the objectives of the study.

The justification for a description of the series used is intended to give a general picture
of the variables with a view to unearth any specific variable properties that may
significantly affect the results of the study. Some of the series possess very large values
and make interpretation of their properties comparatively harder. Therefore, to understand
better, the general distribution of the series and their features, the histograms for both the
raw data and the transformed data are further used in the variable description. The
summary statistics of the variables used in this study shows significant variations in the
mean, median, minimum, maximum, standard deviation, skewness, kurtosis and jarque-
bera values for the different variables as shown in the table below.
 163

6.10. Panel descriptive statistics of the variables

Table 6.1. Panel descriptive statistics of the variables

VARIABLES/ LGIFMP LGIBMP LGGDP INFLN LGREER
DESCRIPTIVE IFMP IBMP GDP REER
Mean 3.155983 3.442762 10.59295 8.285845 2.000161
78793.82 234029.2 7.09E+14 8.285845 101.302
3.5548
Median 3.29124 3.29124 3.488559 2.010704
2019.832
3678.381 5.32E+11 3.488559 102.377

Minimum 0.586079 1.027324 4.639944 -5.334252 1.708988

3.968218 10.77801 1307485 -5.334252 51.16673
Maximum 15.97472
6.188555 6.591093 105.215 2.11893
9.43E+15
1543672 3900253 105.215 131.5011

1.421990 1.370587 3.268027 16.45470 0.074238

Standard Deviation
3.975366 3.721471 2.795757 3.907127 -0.674594
Skewness 0.091516 -1.283011 -0.299434 3.875818 -1.283011
3.940298 3.687815 2.767275 3.875818 -0.670624
18.21773
Kurtosis 2.31727 2.77878 2.279205 5.1297
18.21773
18.63585 15.71074 9.701983 3.633358

Jarque-bera 4.225961 6.729239 7.42802 2394.1 94.05742

2516.539 1772.696 620.1217 2394.1 18.05907
Probability 0.029365 0.029365 0.021890 0.000000 0.000000
0.000000 0.000000 0.000000 0.000000 0.000112
Observations 203 203 203 203 203
197 197 197 197 197

From table (6.1) above, the two dependent variables IFMP which is the proxy for an
Islamic monetary aggregate and IBMP which is proxy for the conventional monetary
aggregate exhibit different minimum and maximum values over the study period. While
IFMP ranged between a minimum value of 3.96 and a maximum of 1543672 with an
average of 78793.82, the IBMP values ranged from a minimum of 10.77 and a maximum
of 3900253 with a mean of 234029.2, respectively. Despite a very significant difference
in the average mean values for both variables, each of them seems to cluster close to its
average value as evidenced from their standard deviation of 3.975 for IFMP and 3.721
for IBMP, respectively. Notably, however, the latter possesses a relatively lower mean
value compared to the former.

The Real effective exchange rate has the lowest standard deviation of -0.674 across the
variables. It recorded a sample that ranged from a minimum of 51.16 to 131.5 maximum
 164

with a mean of 101.30. Expected inflation exhibited the lowest mean value of 8.285 and
the lowest -5.33 minimum value among all the variables. It is standard deviation of 3.90
and a maximum value of 105.21. GDP recorded the largest values of mean, minimum,
maximum but with the second lowest standard deviation.

Figure 6.1. Histograms showing the distribution of each raw data variable for each
cross-section
Bahrain - IBMP Malaysia - IBMP Indonesia - IBMP Kuwait - IBMP Qatar - IBMP Saudi Arabia - IBMP Pakistan - IBMP
80 10,000 16,000 300 2,500 5,000 30,000

8,000 250 2,000 4,000 25,000

60 12,000
6,000 200 1,500 3,000 20,000
40 8,000
4,000 150 1,000 2,000 15,000
20 4,000
2,000 100 500 1,000 10,000

0 0 0 50 0 0 5,000
1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015

Turkey - IBMP Bahrain - IFMP Malaysia - IFMP Indonesia- IFMP Kuwait - IFMP Qatar - IFMP Saudi Arabia - IFMP
4,000,000 40 4,000 12,000 250 1,200 12,000

200
3,000,000 30 3,000
8,000 800 8,000
150
2,000,000 20 2,000
100
4,000 400 4,000
1,000,000 10 1,000
50

0 0 0 0 0 0 0
1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015

Pakistan - IFMP Turkey - IFMP Bahrain - INFLNEX Malaysia - INFLNEX Indonesia - INFLNEX Kuwait - INFLNEX Qatar - INFLNEX
60,000 1,600,000 4 6 60 12 16

50,000 12
1,200,000 8
2 4 40 8
40,000
800,000 4 4
30,000
0 2 20 0
400,000 0
20,000 -4

10,000 0 -2 0 0 -4 -8
1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015

Saudi Arabia - INFLNEX Pakistan- INFLNEX Turkey - INFLNEX Bahrain - GDP Malaysia - GDP Indonesia - GDP Kuwait- GDP
8 25 120 1.6E+10 1.6E+12 1E+16 1.0E+16

20
4 1.2E+10 1.2E+12 8E+15 7.5E+15
80
15
0 8.0E+09 8.0E+11 6E+15 5.0E+15
10
40
-4 4.0E+09 4.0E+11 4E+15 2.5E+15
5

-8 0 0 0.0E+00 0.0E+00 2E+15 0.0E+00

1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015

Qatar - GDP Saudi Arabia - GDP Pakistan - GDP Turkey - GDP Bahrain - REER Malaysia - REER Indonesia - REER
8E+11 2,800,000 1.2E+13 1.6E+12 130 130 120

6E+11 2,400,000 1.0E+13 120 120 100

1.2E+12

4E+11 2,000,000 8.0E+12 110 110 80

8.0E+11
2E+11 1,600,000 6.0E+12 100 100 60

0E+00 1,200,000 4.0E+12 4.0E+11 90 90 40

1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015

Kuwait - REER Qatar - REER Saudi Arabia - REER Pakistan - REER Turkey - REER
140 120 140 130 120

130
120 100
120 100
120
110 80
110
100 80
100 60
100

80 60 90 90 40
1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015

Source: Constructed by the researcher

 165

Figure 6.2. Histograms of the data after being transformed into logarithms
Bahrain - LIFMP Malaysia - LIFMP Indonesia- LIFMP Kuwait - LIFMP Qatar - LIFMP Saudi Arabia - LIFMP Pakistan- LIFMP
1.50 3.6 4.2 2.4 3.2 4.4 4.8

4.0
1.25 2.8 4.0 4.6
3.2 2.0
3.8
1.00 2.4 3.6 4.4
3.6
2.8 1.6
0.75 2.0 3.2 4.2
3.4

0.50 2.4 3.2 1.2 1.6 2.8 4.0

1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015

Turkey - LIFMP Bahrain - LIBMP Malaysia - LIBMP Indonesia- LIBMP Kuwait- LIBMP Qatar - LIBMP Saudi Arabia - LIBMP
6.4 1.8 4.00 4.2 2.6 3.6 4.0

1.6 3.75 4.0 2.4 3.2 3.6

6.0

1.4 3.50 3.8 2.2 2.8 3.2

5.6
1.2 3.25 3.6 2.0 2.4 2.8

5.2 1.0 3.00 3.4 1.8 2.0 2.4

1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015

Pakistan - LIBMP Turkey - LIBMP Bahrain - LGDP Malaysia - LGDP Indonesia - LGDP Kuwait - LGDP Qatar - LGDP
4.6 6.8 10.2 12.2 16.0 18 5.6

4.4 6.4 10.0 12.0 16

15.8 5.2

4.2 6.0 9.8 11.8 14

15.6 4.8
4.0 5.6 9.6 11.6 12

3.8 5.2 9.4 11.4 15.4 10 4.4

1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015

Saudi Arabia - LGDP Pakistan - LGDP Turkey - LGDP Bahrain - INFLNEX Malaysia - INFLNE X Indonesia - INFLNE X Kuwait - INFLNEX
6.5 13.1 12.4 4 6 60 12

6.4 13.0
12.2 8
2 4 40
6.3 12.9
12.0 4
6.2 12.8
0 2 20
11.8 0
6.1 12.7

6.0 12.6 11.6 -2 0 0 -4

1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015

Qatar - INFLNEX Saudi Arabia - INFLNEX Pakistan - INFLNEX Turkey - INFLNE X Bahrain - LEX Malaysia - LEX Indonesia - LE X
16 8 25 120 2.12 2.12 2.1

12 20
4 2.08 2.08 2.0
8 80
15
4 0 2.04 2.04 1.9
10
0 40
-4 2.00 2.00 1.8
-4 5

-8 -8 0 0 1.96 1.96 1.7

1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015

Kuwait - LEX Qatar - LEX Saudi Arabia - LEX Pakistan - LEX Turkey - LE X
2.15 2.08 2.16 2.12 2.1

2.04 2.12
2.10 2.08 2.0
2.00
2.08
2.05 1.96 2.04 1.9
2.04
1.92
2.00 2.00 1.8
1.88 2.00

1.95 1.84 1.96 1.96 1.7

1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015

Source: Constructed by the researcher using E-views 10

From the above categories of histograms, the behavioural trends of the study variables
over the study period does not seem to significantly differ between both forms of data.
 166

Figure 6.3. Histogram for each cross-section

Bahrain Malaysia Indonesia
1.6E+10 1.4E+12 1E+16

1.2E+12
1.2E+10 8E+15
1.0E+12

8.0E+09 8.0E+11 6E+15

4.0E+09 6.0E+11 4E+15

4.0E+11
0.0E+00 2E+15
2.0E+11

-4.0E+09 0.0E+00 0E+00

92 94 96 98 00 02 04 06 08 10 12 14 16 92 94 96 98 00 02 04 06 08 10 12 14 16 92 94 96 98 00 02 04 06 08 10 12 14 16

Kuwait Qatar Saudi Arabia

1E+16 8E+11 3,000,000

8E+15 2,500,000
6E+11
2,000,000
6E+15
4E+11 1,500,000
4E+15
2E+11 1,000,000
2E+15
500,000
0E+00
0E+00 0

-2E+15 -2E+11 -500,000

92 94 96 98 00 02 04 06 08 10 12 14 16 92 94 96 98 00 02 04 06 08 10 12 14 16 92 94 96 98 00 02 04 06 08 10 12 14 16

Pakistan Turkey
1.2E+13 1.6E+12

1.0E+13
1.2E+12 REER
8.0E+12 INFLNEX
IFMP
6.0E+12 8.0E+11 IBMP
GDP
4.0E+12
4.0E+11
2.0E+12

0.0E+00 0.0E+00
92 94 96 98 00 02 04 06 08 10 12 14 16 92 94 96 98 00 02 04 06 08 10 12 14 16

Source: constructed by the researcher.

6.11. The trends of the dependent variables for individual cross sections

An analysis of the trends of the main variables of any regression is always desired. In this
study, the narrow money trends which is the proxy for interest-free monetary policy
aggregate (IFMP) and the broader money as proxy for interest-based monetary policy
aggregate (IBMP) are the key variables. This graphical expression is aimed at
understanding the path that the two main variables have taken over the study period with
a view to unearth the peaks and troughs in the trend and their general behaviour over time
as illustrated below.
 167

Figure 6.4. Trends of the dependent variable for individual cross-sections under the
interest-free monetary system
LIFMP
Bahrain Malaysia Indonesia

Source: Author’s own Construction through E-Views 10

 168

Figure 6.5. Trends of the dependent variable for individual cross sections under the
interest-based monetary system
LIBMP
LIBMP

Bahrain Malaysia Indonesia

1.8 4.0 4.2

4.1
3.8
1.6
4.0
3.6 3.9
1.4
3.4 3.8

3.7
1.2
3.2
3.6

1.0 3.0 3.5

92 94 96 98 00 02 04 06 08 10 12 14 16 92 94 96 98 00 02 04 06 08 10 12 14 16 92 94 96 98 00 02 04 06 08 10 12 14 16

Kuwait Qatar S.Arabia

2.5 3.6 3.8

2.4 3.6
3.2
2.3
3.4
2.2
2.8 3.2
2.1
3.0
2.0
2.4
1.9 2.8

1.8 2.0 2.6

92 94 96 98 00 02 04 06 08 10 12 14 16 92 94 96 98 00 02 04 06 08 10 12 14 16 92 94 96 98 00 02 04 06 08 10 12 14 16

Pakistan Turkey

4.5 6.8

4.4 6.6

6.4
4.3
6.2
4.2
6.0
4.1
5.8

4.0 5.6

3.9 5.4
92 94 96 98 00 02 04 06 08 10 12 14 16 92 94 96 98 00 02 04 06 08 10 12 14 16

Source: Author’s own construction through EViews 10

As can be seen, apart from Indonesia (3), Kuwait (4) and Pakistan (7), that exhibit
significant peaks and troughs particularly around 2008-09 credit crunch period, the trend
for both of our dependent variables across the cross-section, appears to have been
relatively steadily upwards throughout the study period. The figure further suggest the
countries under study have registered significant financial sector development perhaps
due to the rapid growth of Islamic banking and finance since the 1990s. Notably, however,
the different histograms above seem to suggest the existence of contemporaneous
correlation among the different individual in the sample panel. Therefore, before testing
for both the presence of unit root and co-integrations between the dependent and
independent variables, we shall first test for the existence of cross-section dependence in
the data variables of the study as follows.
 169

6.12. Panel Cross-section dependence Tests

As countries become increasingly interconnected, the possibility of both observed and

unobserved variable shocks in one country affecting the economic performance of
another are more likely to occur. This implies existence of cross-section dependence that
result from the presence of a common shock among the sample countries in the panel.
Contemporaneous correlation distorts the size of the unit root and therefore before
modelling any panel dataset from a sample of countries, diagnosis of this issue becomes
crucial to avoid erroneous results and inferences. Our study, therefore, diagnosed whether
the pairwise covariance among the variable residuals are zero or not. This diagnosis is
expressed symbolically by the null against the alternative hypotheses as follows.

: , 0, for all t, i ≠ j

: , 0, for all t, i ≠ j

Based on the above expressions, we began our estimations by testing the null hypothesis
that all the residuals from the standard panel regression are contemporaneously
uncorrelated, against the alternative that they are correlated. Four different tests that
include Pesaran cross-section dependence (CD), Pesaran scaled Langrage Multiplier
(LM), Pesaran (2004), Breusch-Pagan LM, Breusch & Pagan (1980), and Baltagi, Feng
and Kao Bias Corrected scaled (LM), Baltagi, Feng and Kao are employed in this study
(Baltagi, Feng and Kao, 2012). Although Pesaran CD test is hailed as the most appropriate
in the general sense since it considers the challenge of reasonable small sample properties
and takes care of stationary and non-stationary panels, we maintain the other three tests
for comparison to ensure robustness in the results. This is done through diagnosing
whether the pairwise covariance among the study variables is zero or not. The hypothesis
for cross-section dependence is symbolically stated as follows:
 170

Table 6.2. Test results of the cross-section dependence tests for the variables
Bias
Breusch-Pagan Pesaran-scaled
Variabels Stat & Prob. correctedscaled Pesaran CD
LM LM
LM
: No cross-section dependence
Stat. 431.3127* 53.89493* 53.73493* 17.99374*
LNM1
Prob. 0.0000 0.0000 0.0000 0.0000
Stat. 585.2678* 74.46805* 74.3080* 24.06847*
LNM2
Prob. 0.0000 0.0000 0.0000 0.0000
Stat. 532.2182* 67.37899* 67.21899* 18.50813*
LNGDP
Prob. 0.0000 0.0000 0.0000 0.0000
Stat. 103.1368* 10.04057* 9.873906* 4.24558*
INFLNEX
Prob. 0.0000 0.0000 0.0000 0.0000
Stat. 174.4338* 19.56804* 19.40804* 0.637177
LNREER
Prob. 0.0000 0.0000 0.0000 0.52400
Stat. 614.0257* 78.31098* 78.15098* 24.75506*
LNMB
Prob. 0.0000 0.0000 0.0000 0.0000
The subscript * signify a 1% level of significance

From table (6.2) above, apart from the Pesaran CD test of the real effective exchange rate
variable, the rest of the test results reject the null hypothesis of no cross-section
dependence at a 1% significance level. The existence of cross-section dependence in the
variable series has serious implications on the methods and or approaches of unit root
testing that should be employed. The recommended category of unit root testing is the
second-generation approaches that include among others; Peseran cross-section ADF
(PESCADF), Cross-section I’m Pesaran and Shin (CIPS).

6.13. Panel unit root tests

Stationary of the series is a requirement for the results of the estimation not to be spurious.
There are broadly two categories of unit root tests: conventional unit root tests and the
panel unit root tests. Panel unit tests also take different kinds based on their underlying
assumptions. Compared to the conventional unit root tests such as the Augmented Dick
Fuller (ADF) and Phillips-Perron (PP), panel unit root and co-integration testing
approaches have many advantages. For example, finite sample performance improves
significantly when time series are pooled across cross-sections. Besides these
conventional unit root tests suffer from low power performance when applied to a small
sample size compared to panel unit root tests over univariate testing procedures as
demonstrated by various studies including Stern (2011), Im, Pesaran, and Shin (1997,
2003), and Levin and Lin (1992, 2002).
 171

Similarly, various studies confirm the power improvement feature of panel co-integration
approach when compared to the co-integration testing under the conventional models.
Such works by Pedroni (1997, 1999, 2004), Mark and Sul (2001), Ann and Oh (2001),
and Oh (1996) are good examples. Also, panel data estimations provide more useful
information upon which relevant inferences are made regarding the nature of economic
systems and their corresponding set of equations for groups of countries compared to
single equations made under time series analysis.

Although pre-testing the series for stationary is not a pre-requisite for any estimation
using a panel ARDL model, the inclusion of series that are integrated of order I(2) causes
such a regression to collapse. As for the Dynamic OLS and the Fully Modified OLS, the
variables need to be integrated of a specified order. Therefore, the panel unit root testing
in this study is aimed at determining both the order of integration and ascertaining that no
variable is integrated of order I(2) as already mentioned.

In this study both first generation and second-generation kinds of panel unit root tests
based on their underlying assumptions and advantages were employed. Among the first
generations; (i) Levin, Lin and Chu, and (ii) I’m, Pesaran and Shin were employed based
on their superiority over individual unit root tests as elucidated above. According to
Levin, Lin and Chu (2002) panel unit root testing takes different specifications based on
the assumptions made on the intercept terms and the time trends in a particular entity. The
basic assumption of this unit root test is the infliction of homogeneousness in the entity
in which both the intercept and time trend terms can vary across the cross-section and
hence forth mitigates the impact of cross-sectional dependence which is not only a
common occurrence in panel data estimations but also confirmed in our data sample. LLC
testing is based ADF unit root. The general AR form of this unit root process is expressed
as follows.

∆ , ∑ ∆ , , (6.12)

Where; is the constant term and differs across the cross-section, p is an autoregressive
(AR) coefficient which is identical across the cross-sectional entities. is the lag order
and , is the disturbance term that follows an ARMA stationary process and takes the
form below.
 172

, ∑ ∆ , , (6.13)

The hypotheses for this are stated as follows.

Null: : 0
ALT: : 0 for all the cross sections.
The LLC model based on t-statistics with which the p value remains fixed across the
entities for both the null and the alternative hypotheses. The t-statistics is expressed as
follows.

(6.14)

When the entity contains heterogeneity in the cross section, I’m, Pesaran and Shin (2003)
becomes the most appropriate to check the panel unit root. Like the LLC model, IPS is
also based on ADF methodology to test the individual series. However, in this method,
the t-statistics is based on an arithmetic mean for the individual series. The panel unit root
under the Augmented Dick Fuller format can be written as follows:

∆ , ∑ ∆ , , (6.15)

The IPS unit root equation, which unlike the LLC model, allows for the heterogeneity in
the value, is written as follows.

∑ , Ƿ (6.16)

Where; , represents the ADF t-statistics and Ƿ stands for the lag order. In its full form,
the t-statistics is calculated using the following formulae.

(6.17)

The requirement for applying an ARDL model is that variables are integrated either at
level I(0) or after first difference I(1) or both but not of order I(2) is critical for credible
estimations (Breitung & Pesaran, 2008; M. H. Pesaran et al., 1996)The difference
between these two types of tests is that while Im, Pesaran and Shin (IPS) assumes an
individual unit root process, Levin, Lin & Chu (LLC) assumes a common unit root
process (Levin et al., 2002; Pesaran et al, 1999).
 173

Murthy & Okunade, 2016)The table below shows the results of these panel unit root tests
at two stages: (i) with intercept and the other (ii) With trend and intercept:

Table 6.3. Panel unit root tests using first generation techniques.
LEVEL
With intercept Intercept With trend
Variable t-statistic t-statistic

LLC -0.67055 -0.27894

LM1 (IFMP) IPS 1.75190 -1.16006
LLC -3.48665* -3.12894*

LM2 (IBMP) IPS -0.70813 -2.34856*

LLC 5.28344 36.1272
LGDP IPS 4.02062 -1.80243**
LLC -4.86961* -1.84096**
INFLATION IPS -5.37221* -3.23088*
LLC -0.41980 2.58600
LREER IPS -0.14094 0.36405
LMB LLC -1.174 1.324
IPS 1.433 1.559
FIRST DIFFERENCED
With intercept With trend and intercept
statistics statistics

LM1 (IFMP) LLC -8.15698* -6.17216*

IPS -7.93418* -5.25410*

LGDP LLC -298.763* -259.979*
IPS -108.704* -105.326*

LM2(IBMP) IPS -5.02714*

LREER LLC -9.42786* -6.81633*

LMB LLC -6.555* -5.559*

IPS -5.830* -4.607*
The subscript *, ** represent 1% and 5% level of significance, respectively as determined from the P-values
which are not reported. While the existence of the subscript (s) confirm the significance, their absence
implies that the statistic is nonsignificant at that level.
 174

From table (6.3), apart from the expected inflation rate, which is stationary at level, all
the variables become fully stationary after first difference. However, although the above
two panel unit roots produce robust results since they possess higher power in small
samples as the case is in this study (Hlouskova and Wagnar, 2006), they sometimes give
spurious estimates and inferences since they operate under the assumption of cross-
section independence of the series under study. So, where the variables in the panel
exhibit cross-sectional dependence, regression analysis made based on the above two
approaches become susceptible to errors.

Therefore, to augment the above results considering the cross-sectional dependence

problem found in the data sample, we performed one additional panel unit root test which
falls under the second-generation category: Pesaran separate cross-section ADF
(PESCADF). The technique allows for cross-section dependence through augmenting the
standard Augmented Dick Fuller regression with lagged and first differences averages of
the individual cross-section variables. The test equally allows each panel member to have
different AR parameters. The latter technique is simply the average statistic of the
individual CADF statistics whose critical values are tabulated (Peseran, 2007). The test
is expressed as follows.

The PESCADF:

∆ ∑ ∆ ̄ ∑ ∆ ̄ (6.18)
Where ̄ = ∑ is the cross-section mean of .

Like the first-generation techniques, the null hypothesis ( ) for this test is that the
variable series contain unit roots. The alternative hypothesis ( ) states that at least one
individual series is trend stationary. The underlying sufficient condition for employing
the second-generation techniques states that the variables should not be stationary at level
but become stationary after being first differenced. Once this sufficient condition is
satisfied, then the cointegration possibility is confirmed to exist in the variables of the
model (Tuğcu, 2018, p. 11). We focused on the constant and trend statistics which is
considered more robust and the results were as follows.
 175

Table 6.4. Panel unit root tests using the second-generation technique
VARIABLE PESCADF

Constant and Trend

Z[t-bar] P-value
LM1(IFMP) -0.627 0.265
LM2 (IBMP) 1.610 0.946
LGDP 0.833 0.797
INFLNEX 1.197 0.884
LREER 0.734 0.768
LMB 0.389 0.651

∆LM1(IFMP) -2.423* 0.008

LM2 (IBMP) -3.166* 0.001
∆LGDP -2.496* 0.006
INFLNEX -3.424* 0.000
∆LREER -2.348* 0.009
∆LMB -2.209** 0.014
The subscript ∆ signify first difference operator while * and ** imply significance at the 1% and 5% levels,
respectively. While the existence of the subscript (s) confirms the significance, their absence implies that
the statistic is nonsignificant at that level.

From table (6.4) above, all the variables contain unit root at level but after taking their
first difference, they all become stationary. Therefore, while the null hypothesis cannot
be rejected at level, it is rejected after the first difference as indicated the by the subscripts
(*, **) that signify significancy of the statistics at 1% and 5%, respectively. Thus, the
sufficient condition for applying the second-generation panel unit root tests which require
the estimated variables not to be level stationary but stationary after the first differenced
is fulfilled as per the above results.

Since the study looks at both the panel and individual cross-sections, ascertaining the
existence of unit roots in both cases becomes necessary. Having investigated the level of
integration and stationery for the panel data set above, we now turn to the individual
cross-sections. Using Phillips-Peron unit root test, the outcomes of the tests are as shown
in the table that follow.
 176

The log of the dependent variable under the Islamic monetary system (M1) possesses unit
root for all the cross-sections at level but turns into stationary at first difference. Also,
apart from Malaysia results that is stationary at 1% at level, the log for the dependent
variable under the conventional system (M2) also has unit root at level but becomes
stationary after being first differenced. The log of the scale variable (real income) equally
possesses unit root at level for all the eight countries and turns into stationarity after being
first differenced except for Kuwait which is stationary at 1% statistical significance level
at level.

Table 6.5. Country specific unit roots (Phillips-Perron)

SERIES Bahrain Malaysia Indonesia Kuwait Qatar S.Arabia Pakistan Turkey
LIFMP 0.9241 0.9915 0.702 0.71 0.959 0.9906 0.169 0.991
∆LIFMP 0.012** 0.0042* 0.000* 0.002* 0.061* 0.035** 0.000* 0.004*

LIBMP 0.8026 0.000*** 0.292 0.7706 0.911 0.825 0.1285 0.8901

∆LIBMP 0.0061* - 0.004* 0.007* 0.045** 0.053** 0.003* 0.007*

LGDP 0.7264 0.9765 0.965 0.000* 0.939 0.997 0.943 0.943

∆LGDP 0.0016* 0.0007* 0.013** - 0.018** 0.001* 0.012** 0.012**

INFLNEX 0.0392** 0.776 0.005* 0.078*** 0.096*** 0.2102 0.291 0.2917

∆INFLNEX - 0.000* - 0.000* 0.000* 0.000* 0.000* 0.000*

LEX 0.609 0.66 0.114 0.964 0.844 0.566 0.536 0.536

∆LEX 0.0068* 0.000* 0.000* 0.003* 0.047** 0.009* 0.005* 0.005*

LMB 0.6869 0.1734 0.444 0.872 0.93 0.997 0.981 0.9812

∆LMB 0.0146** 0.007* 0.013** 0.004* 0.000* 0.001** 0.000* 0.000*
Notes: The subscripts *, ** and *** show stationarity of variables at 1%, 5% and 10%, respectively. While
the existence of the subscript (s) confirm the significance, their absence implies that the statistic is
nonsignificant at that level. The subscript ∆ signify first differenced variable coefficients. Source:
constructed by the researcher through stata.

For expected inflation rate, it is non-stationary at level for all the countries except Bahrain
and Indonesia that are stationary at their levels at 5% and 1% significance levels,
respectively. The non-stationary ones become stationary at 1% statistical significance
only after first differencing. Real expected exchange rate possesses unit root for all the
 177

countries at level and becomes stationary at first difference. Lastly, the monetary base
variable is non-stationary for all the countries and becomes stationary at first difference
at 1% statistical significance.

In conclusion, the individual country and variable stationary test reveal a mixed
integrations; at level I(0) and at first differenced I(1) but none is of I(2). Therefore, an
ARDL approach seems to be the most appropriate for running the short run co-integration
test for our sample. We examine the co-integration properties our variable before running
the estimations in the following sub-section.

6.14. Panel cointegration tests

Cointegration testing of time series was first introduced in the 1980s through the early
1990s. Before estimating any sort of equation, ascertaining the existence of a long-run
relationship between and or among the variables of the study is considered not only
important but also crucial to avoid spurious results and wrong inferences such as
confirming causality and order of co-integration where none does exist. Some of the most
outstanding studies on co-integration testing that is mentioned across economic literature
include Engle and Granger (1987), Johansen (1988, 1992), Johansen and Juselius (1990,
1992), among others. Subsequent studies extended these cointegration techniques and
applied them to panel datasets. Surveys including dynamic panels, panel cointegration,
non-stationary panels in Baltagi (2001, Ch. 12), Banerjee (1999), Baltagi and Kao (2000),
and most recently Westerlund (2007), and Nsiah (2016) are always sited as good
examples in panel cointegration approaches.

In our study, we employ panel cointegration methodologies by Pedroni (1999, 2000,

2004), Kao (1999, 2000, 2002), and a fisher-type test based on underlying Johansen
(Maddala &Wu, 1999). Westerlund panel cointegration approach is recommended where
the sample data variables exhibit contemporaneous correlation that results into serial
correlation. Therefore, we also conducted a Westerlund panel cointegration test.

6.14.1. Pedroni panel cointegration testing

Pedroni extended the Engle and Granger (1987) two-step cointegration technique to panel
data by proposing 11 cointegration tests that are categorised into 3 major test statistic.
The first category comprises of 4 panel statistics; panel v., which is a nonparametric
 178

variance ratio statistic, panel p., a nonparametric Phillips-Peron type p-statistic, panel pp.,
a nonparametric Phillips-Peron type t-statistic and Panel ADF, a Dick Fuller t-statistics.

The second category consists of the same panel statistics but in this case, they are
weighted by long-run variances. The third category contains three group statistics that
include Group p (Phillips and Perron-type p-statistics), Group pp (Phillips and Peron-type
t-statistics) and lastly an ADF-type t-statistics (Group ADF). Using Fully Modified
Ordinary Least Squares (FMOLS) principles, Pedroni (2000) developed those new
methods for hypothesis testing of cointegrating vectors in dynamic panels.

6.14.2. Kao panel cointegration test

The second cointegration model that this study employs is the Kao (1999) panel
cointegration test which was developed basing on DF and ADF and the standard approach
employed by the EG-Step procedures. The test starts with a general panel regression
model as stated below;

(6.20)

Where; X and Y are assumed to be nonstationary variables;

^ ^
(6.21)

^ ^ ^
Where; resents residual estimationsfrom the
general panel regression above. Basing on this residual equation, a null hypothesis of no
cointegration, : P = 1 is regressed against the alternative test that X and Y variables are
cointegrated, : P 1. The cointegration test statistics that Kao (1999) developed
including the DF-type and ADF test statistics and also panel DF-type( 4 type) test
statistics and ADF test statistics are expressed as follows;

– √
. (6.22)
⁄

(6.23)
 179

ῤ
DF ∗

(6.24)

∗
= (6.25)

ADF = (6.26)

^
Where; N = Cross-section data, T= Time series data, = coefficiencies of the regression
^ ∑ ^∗
variables 1 √∑ 1 / ,, Se=
^∗ ^ ^∗ ^ ^
1⁄ ∑ ∑ ∑ ii t 1 , = variance of u, = variance
^ ^ ^
of v, = standard deviation of u, = standard deviation of v and

1 ∑ /

6.14.3. Johansen/Fisher panel cointegration test

The third and final co-integration test that we employ in this study is Johansen test. Both
ADF and PP- test statistics have similar null hypothesis of no co-integration, Maddala
and Wu (1999) combined Fisher and Johansen to develop an alternative model of testing
for panel data co-integration. The advantage of this approach is that it combines all the
individual section-sections to produce a single test statistic for the full panel dataset. The
Johansen panel co-integration starts with the following model

2∑ → 2n (6.28)

From the model above, the is based on P- value use for Johansen’s two co-integration
tests: trace and maximum eigenvalue and Johansen’s maximum likelihood procedure,
MacKinnon-Haug-Michelis (1999). This is what the following equation expresses.

∆ , ∏ , ∑ ∆ , , (6.29)
 180

The null and alternative hypothesis in this case is stated as follows;

While ∶ ∏ 1, … , , ∶ ∏ for all i

from 1 to n respectively. Accordingly, by employing the mean of each cross-section, and
the averages, plus variance of trace statistics, a panel cointegration rank Trace statistic is
computed.

6.13.4. Durbin-Hausman panel cointegration test

As earlier pointed out, drawing inferences on cointegration results based on the earlier
three panel techniques alone is considered erroneous since the techniques do not consider
the cross-sectional dependence challenges associated with panel annual datasets.
Moreover, from the cross-section dependence tests we conducted as shown in table 6.2,
the null hypothesis of no cross-section dependence was rejected. Therefore, other
methodologies that solve the serial correlation challenges associated with cross-
sectionally dependent panel data variables becomes the most preferred technique. We
found the Durbin-Hausman panel cointegration test developed by Westerlund (2008)
most appropriate.

The basic requirement for applying this panel test is that the dependent variables should
strictly be integrated of order I(1) while the explanatory variables can be integrated of
orders either I(0) or I(1) but not both (Govdeli, 2019, p. 501). There are two distinct kinds
of this technique, the Durbin-Hausman group mean test, while the second is the Durbin-
Hausman panel test. This test possesses two main advantages over the earlier
cointegration test. First, it exhibits higher powers than the other tests where both the
number of observations is small and the time from considered and secondly but most
importantly, it maintain the nominal size well in small samples, contrary to Pedroni
(2004) suggestions such as demeaning the data with respect to a common time effect
(Hashem & Pesaran, 2014, p. 207). Also, since the independent variables may be
stationary, it implies that a very simple test procedure that does not involve any unit root
prior testing is likely to reduce the overall uncertainty of the test. This justifies our choice
for the test since our dataset contains few observations.

As expected, the two tests are expressed differently as shown below. The significance of
this distinction lies in the formulation of the alternative hypothesis. For the panel test, the
null and alternative hypotheses are formulated as : ∅ 1 for all I 1, … . , n versus
 181

∅ ∅ and ∅ 1 for all i. By contrast, under the group mean test, the hull
hypothesis is tested versus the alternative that :∅ 1 for at least some i. In both
tests, a multiplicative correction method is employed to account for the effects of serial
correlation which is commonly associated with panel datasets (Hashem & Pesaran, 2014,
p. 203).

The Durbin-Hausman group mean test.

∑ ̂ ∅ ∑ (6.30)

The Durbin-Hausman panel test.

̂ ∅ ∑ ∑ (6.31)

Where ̂ two variance ratios, the quantity which is a consistent estimate of the long
run variance for the OLS residual terms and the corresponding contemporaneous variance
estimate, the number of units for which the no cointegration restriction ∅ 1 is to
be tested, Although the number can be equal to N, it can equally be a subset, ∅ the
OLS estimators ∅ and ∅ denotes its pooled counterpart. The ∅ denote the
corresponding individual and pooled instrumental variable estimators of ∅ ,
estimated idiosyncratic error terms.
 182

Panel A. Table 6.6. Panel cointegration tests results

Test statistics Constant without trend Constant with trend
Panel statistics (Within-dimension)

Panel v-Statistic 0.516105 (0.3029) 0.962502 (0.1679)

Panel rho-Statistic 0.065984 (0.5263) 0.608521 (0.7286)

Panel PP-Statistic -1.305616 (0.0958) * -2.121116 (0.017) **

Panel ADF-Statistic -1.882061 (0.0299) ** -2.273394 (0.0115) **

Panel statistics (Weighted)

Panel v-Statistic 0.526819 (0.2992) -0.224485 (0.5888)

Panel rho-Statistic -0.386692 (0.3495) 0.273005 (0.6076)

Panel PP-Statistic -2.158928 (0.0154) ** -2.75483 (0.0029) *

Panel ADF-Statistic -2.308709 (0.0105) ** -2.967369 (0.0015) *

Group statistics (Between-dimension)

Group rho-Statistic 0.862821 (0.8059) 1.415911(0.9216)

Group PP-Statistic -1.687259 (0.0458) ** -2.870648 (0.002) *

Group ADF-Statistic -1.923454 (0.0272) ** -3.056621 (0.0011) *

Kao Residual cointegration test

ADF -2.23789 (0.0126) **

Johansen/Fisher panel cointegration test

Fisher stat. from trace test 77.84 (0.0000) * 79.85 (0.000) *

Fisher Stat. from the 65.36 (0.0000) * 92.16 (0.000) *

max. eigen value test
Durbin-Hausman panel cointegration test
DH g statistics DH p statistics

159.008 (0.000) * 16.076 (0.000) *

Notes: The test statistics are distributed as N (0,1). ADF, Augmented Dickey–Fuller. The subscript *, **
and *** imply Significance at 1%, 5% and 10% levels, respectively. While the existence of the subscript
(s) confirm the significance, their absence implies that the statistic is nonsignificant at that level.

From table (6.6) above, the null hypothesis of no cointegration was rejected by all the
four panel cointegration techniques employed. Therefore, cointegration exists among the
money demand function variables considered by the study under the interest-free
(Islamic) monetary system.
 183

Panel B. Table 6. 7. Panel cointegration tests results

Test statistics Constant without trend Constant with trend
Panel statistics (Within-dimension)

Panel v-Statistic 0.376388 (0.3533) 0.59294 (0.2766)

Panel rho-Statistic 0.510396 (0.6951) 0.501011(0.6918)
Panel PP-Statistic -0.789771 (0.2148) -1.444231 (0.0743) *
Panel ADF-Statistic -1.204128 (0.1143) -0.680204 (0.2482)
Panel statistics (Weighted)
Panel v-Statistic 0.650011 (0.2578) 0.248798(0.4018)
Panel rho-Statistic 0.340706 (0.6333) 0.678526 (0.7513)
Panel PP-Statistic -0.678331 (0.2488) -0.810517 (0.2088)
Panel ADF-Statistic -0.919204 (0.179) -0.224286 (0.4113)
Group statistics (Between-dimension)

Group rho-Statistic 1.434876 (0.9243) 1.696953 (0.9216)

Group PP-Statistic -0.220418 (0.4128) -0.447152 (0.3274)
Group ADF-Statistic -1.204128 (0.3243) 0.635187 (0.2627)
Kao Residual cointegration test
ADF -3.177334 (0.0007) *
Johansen/Fisher panel
cointegration test
Fisher stat. from trace test 129.7 (0.0000) * 123.7 (0.000) *
Fisher Stat. from the max. 94.86 (0.0000) * 82.87 (0.000) *
eign value test
Durbin-Hausman panel cointegration test
DH g statistics DH p statistics
66.588 (0.000) * 16.343 (0.000) *
Notes: The test statistics are distributed as N (0,1) Augmented Dickey–Fuller (ADF). The subscripts *, **
and *** imply significance at the 1%, 5% and 10% levels, respectively. The figures in the brackets are the
P-values. While the existence of the subscript (s) confirm the significance, their absence implies that the
statistic is nonsignificant at that level.

From table (6.7) above, majority of the test techniques employed rejected the null
hypothesis of non-existent of cointegration relationship between the dependent and the
independent variables for the interest-based money demand function. The rejection is
 184

highly significant at 1%. Whereas the cointegration results for the first three techniques
were arrived at using Stata, the Westerlund results were arrived at using Gauss
application.

6.14. Panel causality test using both the pairwise Granger causality and Dumitrescu-
Hurlin panel causality tests

Basing on the above tests, we also checked and analyzed the causality through the
pairwise directions; aimed at testing for the uni-directional and bi-directional causality
between the variables of the study for the eight selected Muslim majority Countries by
applying the Engle Granger causality and Dumitrescu-Hurlin tests. Granger causality test
has dominated econometric literature since the late 1960s as the most appropriate when
all the coefficients are the same across all the cross-sections (Engle and Granger, 1987;
Hhurlin and Venat, 2001). The superiority of panel Granger causality approach is based
on 03 key points; (i) Research model deviations and errors are highly minimized under
this test, (ii) the approach controls consistency between the different objects in the dataset
and (iii) the above two reasons combined increase the reliability of the regression results
from this test technique.

On the other hand, if cross-section dependence is present in the sample data as the case is
in this study as the results from the contemporaneous correlation tests confirm beyond
any doubts, Dumitrescu Hurlin test is recommended as the best approach for testing panel
causality test, Dumitrescu and Hurlin (2012). This is because, Dumitrescu-Hurlin test
technique allows for differences in all the coefficients across the cross-section. However,
when more than one test is used and the outcomes compared, such results are hailed as
robust. We, therefore, ran the two pairwise panel causality tests but inferences made
largely based on the latter approach.

6.14.1. Pairwise panel Granger-causality test

Engle and Granger (1987), postulates that once two non-stationary variables are co-
integrated, a Vector Auto regression (VAR) in first differences will be mis-specified.
Therefore, in this study, a model with a dynamic error correction representation is
specified under the assumption that the demand for the real money balances is co-
integrated with its determinants. A lagged one period error correction term obtained from
 185

the co-integration model is used to augment the traditional VAR in this case. The Granger
causality tests in this study follows the following forms.

∆lnM1 ∑ ∆ln 1 ∑ ∆ln

∑ ∆lnIFLN ∑ ∆ln 1 (6.32)

∆lnM2 ∑ ∆ln 2 ∑ ∆ln

∑ ∆INF ∑ ∆ln 2 (6.33)

∆ ∑ ∆ln ∑ ∆ ∑ ∆lnEX
∑ ∆lnM1 3 (6.34)

∆ ∑ ∆ln ∑ ∆
∑ ∆ln ∑ ∆lnM1 4 (6.35)

∆ ∑ ∆ln ∑ ∆ln ∑ ∆INFN

∑ ∆lnM1 5 (6.36)

The subscript ∆ denotes the first difference of the variable, ECM denotes the error
correction model, p is the lag length obtained using Akaike Information Criterion (AIC)
and the rest of the variables are as previously defined. Whereas first differencing is very
important in that it provides evidence on the short-run causation direction, t-statistics on
the one period lagged ECM denotes the long-run causation direction. According to
Narayan and Smyth (2008) F-statistics for test provides better results on the short-run
causality direction in panel datasets and so we follow their approach.

6.14.2. Pairwise Dumitrescu Hurlin panel causality test

This is a simple version of the Engle granger non-causality test (1969). Developed to test
heterogeneous data models with fixed effects, Hurlin (2012) takes two distribution tests:
i) Asymptotic test, and ii) Semi-asymptotic test. Whereas Asymptotic distribution test is
applied when the T > N, the Semi-asymptotic test is used where T ˂ N. However, in case
of cross-sectional dependence in the data set, simulated and approximations of critical
 186

values that are obtained from 50,000 replications are used. Below are the results of the
causality test.

Table 6. 8. Pairwise panel causality tests with M1 (LIFMP) as the dependent variable
Causality test for model 1 (M1 / LIFMP) Granger causality Dumitrescu Hurlin panel causality
Null Hypothesis: F-Stat Prob. W- Zbar- Prob.
Stat. Stat.
LGDP does not cause LM1 0.6055 0.4374 3.18231 3.50518 0.0005
LM1 does not cause LGDP 3.94545 0.0484 14.0121 21.735 0.0000

INFLNEX does not cause LM1 0.86409 0.3538 2.28142 1.96218 0.0497
LM1 does not cause INFLNEX 0.91699 0.3395 2.79505 2.81907 0.0048

LEX does not cause LM1 0.02013 0.8873 1.53593 0.73187 0.4642
LM1 does not cause LEX 1.6286 0.2034 1.31981 0.36849 0.7125

INFLNEX does not cause LGDP 0.78504 0.3767 1.79611 1.15254 0.2491
LGDP does not cause INFLNEX 0.26299 0.6087 1.12103 0.0263 0.979

LEX does not cause LGDP 0.14917 0.6998 2.19842 1.84579 0.0649
LGDP does not cause LEX 1.2719 0.2608 2.52432 2.39376 0.0167

LEX does not Granger Cause 0.10249 0.7492 2.73417 2.71751 0.0066
NFLNEX
INFLNEX does not Granger Cause 3.88056 0.0503 4.44466 5.57111 3.00E-08
LEX

From table (6.8) above, the null hypothesis that LGDP does not cause LM1 (LIFMP) and
vice versa is rejected at a 1% level of significance. Similarly, the null hypothsis stating
that INFLNEX does not cause LM1 (LIFMP) and viceversa is equally rejected at a 5%
and 1% significance levels respectively. Contrary to the above causality tests, the case of
LEX does not cause LM1 (LIFMP) and viceversa can not be rejected.
 187

Table 6.9. Pairwise panel causality tests with M2 / LIBMP as the dependent variable
Causality tests for model 11 (M2/ibmp) Grangery causality Dumitrescu Hurlin Panel Causality
Null Hypothesis: F-Stat Prob. W-Stat. Zbar-Stat. Prob.
LGDP does not Cause LM2 4.94527 0.0273 4.49615 5.71677 1.E-08
LM2 does not Cause LGDP 3.94699 0.0483 13.3049 20.5446 0.0000

INFLNEX does not Cause LM2 2.80169 0.0958 2.41058 2.17765 0.0294
LM2 does not Cause INFLNEX 0.65173 0.4205 1.01656 -0.14799 0.8823

LEX does not Cause LM2 0.19741 0.6573 1.09218 -0.01426 0.9886
LM2 does not Cause LEX 2.26647 0.1338 2.84983 2.94108 0.0033

INFLNEX does not Cause LGDP 0.78504 0.3767 1.79611 1.15254 0.2491
LGDP does not Cause INFLNEX 0.26299 0.6087 1.12103 0.02630 0.9790

LEX does not Cause LGDP 0.14917 0.6998 2.19842 1.84579 0.0649
LGDP does not Cause LEX 1.27190 0.2608 2.52432 2.39376 0.0167

LEX does not Cause INFLNEX 0.10249 0.7492 2.73417 2.71751 0.0066
INFLNEX does not Cause LEX 3.88056 0.0503 4.44466 5.57111 3.E-08

As pointed earlier, the aim of the causality was to examine the panel causality
relationships among the variables of the study. Since our data is annual one, the results of
the causality tests are based on an optimal lag length of one (1) obtained using Akaike
information criterion (AIC). In both models, we find statistically significant causal
relationships between the dependent and independent variables. Comparing both tests,
Dumitrescu Hurlin panel causality test seemingly provide robust results and therefore the
analysis of the causality is based on it.

In model 1, we fail to reject the null hypothesis of no causality between real money
demand balances and the scale variable of real GDP (income) at a 1% significance level.
We thus observe a bi-direction causality relationship between money demand (M1/IFMP)
and GDP. This is supported by the economic theory in that expansionary monetary policy
other factors constant facilitates consumption and investment expenditures especially
when the economy’s equilibrium is below the full employment level. Similarly, an
increase in the level of transactions (economic activities) prompts an increase in the
 188

demand for money. Similarly, the results indicate a bi-direction relationship between
INFLNEX and M1/IFMP.

The significance level, however, differs between the two variables. While the null
hypothesis non-causation running from expected INFLNEX to M1/IFMP is rejected at a
5% significance level, the rejection of the null hypothesis of non-causation running from
M1 to INFLNEX is at 1% significance level. This is in line with the economic theory in
that the rate of growth of inflation follows that rate of increase in money growth in an
economy (Abdullah & Yusop, 1996). When expected inflation is anticipated to rise than
what may currently be, rational economic agents move their portfolios from cash to real
assets and as a result demand for money increases. In the same way, expansionary
monetary policy brings about inflationary tendencies in an economy as postulated by the
monetarist theory, (Friedman and Schwartz, 1963; Laidler, 1980).

For real effective exchange rate (EX) to money demand (M1/IFMP), from M1/IFMP to
EX and INFLNEX to GDP and from GDP to INFLNEX, the null hypothesis of no
causation relation between each pair of these variables could not be rejected. Between EX
and GDP, the null hypothesis of no causality was rejected at 10% significance level, while
between GDP and LEX, the null hypothesis was rejected at a 5% level of statistical
significance. So, there is a bi-direction causation between EX and GDP, and these results
are in conformity with the economic theory too whereby following a currency
depreciation in a floating exchange regime, the domestic goods become relatively cheaper
in relation to the international currencies thereby inducing high production for the
international market. This increases aggregate expenditures due to increased net
expenditure on exports (Calvo et al., 1995).

Consequently, as the exchange rate rises, the cost of imports of both raw materials and
investment goods increases. As a result, production costs increase through these imported
inputs and so, cost-push inflation will rise. Specifically, where the exchange rate pass-
through is greater, the rate of imported inflation transmission amongst trading countries
rises rapidly.

Between EX and INFLNEX, there is a uni-direction causality running from real effective
exchange rate to expected inflation rate. This is because the null causality from EX to
INFLNEX, is rejected at a 1% significance level. The increased aggregate demand from
 189

the international market following a depreciation in the domestic currency rises inflation
behaviour (imported inflation) in the economy (Komárek & Melecký, 2001).

Model 11, where M2/IBMP is the independent variable as a proxy monetary policy
aggregate for the interest-based money, the results from the two causality tests are quite
different compared to when M1 / LIFMP was used as proxy. Whereas the result from the
Granger causality indicates the existence of a bi-direction causality between M2/IBMP
and the scale variable Real GDP (income) and vice-versa as the null of noncausality
between the two pairs of variables were rejected at a statistical significance of 5%, the
Dumitrescu Hurlin (DH) panel causality test revealed only a unitary causality relationship
running from M2/IBMP to GDP. The latter implies that as the conventional central bank
undertakes expansionary monetary policy by way of lowering its policy rate, this action
translates into higher availability of credit, lower interest rates, in the business sector and
increased consumer and investment expenditures in the economy. Consequently,
aggregate demand and supply in the economy increases in the short run as postulated by
different macroeconomic theories especially the Keynes’ theory.

On INFLNEX and M2/IBMP, there is only one causal link running from INFLNEX to
M2/IBMP as the null hypothesis of non-causality was rejected at 10% and 5% statistical
significance level by EG causality and DH panel causality tests, respectively. This causal
link is in line with the economic theory as earlier mentioned (Komárek & Melecký, 2001).
Similarly, the rejection of the null hypothesis of causation running from M2/IBMP to
INFLNEX is not contrary to the broader body of macroeconomics. It simply affirms the
new classical rational expectational hypothesis (REH) over the adaptive expectational
hypothesis (AEH) propounded by the monetarist economic theory. In other words, since
inflation is considered a tax (inflation tax), a high expected inflation rate implies increased
cost of holding money in relation to assets. Therefore, rational economic agents reduce
on their real money holdings, thereby decreasing on their demand it.

Between EX and M2/IBMP, the null hypothesis could not be rejected. However, the null
hypothesis of M2/IBMP not causing EX is rejected at a statistical significance level of
1%. This is straight forward in that increased money supply (M2 in this case) induces the
depreciation of the domestic currency against the international currencies (Levin, 1997).
This eventually leads to an increase in inflation rate and the expected inflation rate to
jump up in the economy.
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6.15. Empirical Estimations

The estimations starts off with results from the panel cointegration regressions based on
the FMOLS and DOLS estimators both for the interest-free monetary system and the
conventional based system. We then estimate the short-run relationships using the ARDL
approach. The results from the ARDL estimations are used to plot the CUSUM and
CUSUM squares that provide the basis for determining the stability of the model. We
then estimate the volatility of the velocity for the two monetary aggregates and end with
correlation between the monetary aggregates and the monetary base plus that of price and
the monetary aggregates before briefly discussing results and drawing the necessary
conclusions.

6.15.1. Long-run panel estimation

The regression results under this section follows the 5.3 and 5.4 Dynamic OLS and Fully
Modified OLS equations as specified earlier. The estimations are as follows:

Table 6.10. Results of panel estimation of cointegrating regression under Interest-free

monetary policy (IFMP)
FMOLS DOLS
Cointegreting regression Pooled Weighted Grouped Pooled Weighted Grouped
LGDP 1.719* 1.664* 1.751* 1.652* 1.636* 1.794*
(-0.091) (0.009) (0.073) (0.089) (0.055) (0.102)
INFLNEX -0.004* -0.064** 0.006* -0.003* -0.002* 0.021*
(0.0009) (0.025) (0.003) (0.001) (0.0008) (0.005)
LEX -0.727* -0.496* -0.817* -0.540*** -0.434* -0.526***
(0.3005) (0.020) (0.241) (0.290) (0.157) (0.311)
Note: In FMOLS and DOLS (Pooled), estimation coefficient of covariance was computed using sandwich
method. Numbers in the parenthesis indicate standard error. Subscripts *, ** and *** indicate 1%, 5% and
10% significance levels respectively while n signifies non-significant coefficient results.

From table (6.10) above, as expected we find real income (GDP) has a positive and
statistically significant impact on the real money balances at a 1% level in both
approaches. The long-run money demand functions under both systems are consistent
with the existing monetary literature. The positive impact implies that the money demand
balances responds to an increase in transaction / economic activities in an economy,
which implies a reverse causation as postulated by the real business cycle theory (RBC).
 191

Similarly, the outcome of the regression result exhibits that the signs for the estimated
coefficients are in conformity with the theoretical literature.

As can be seen in the table, the FMOLS regression results are not quite different from
those of the DOLS estimates under the pooled, pooled (weighted) and grouped estimators.
The scale variable (real GDP) coefficients range from 1.719, 1.664, and 1.751 for FMOLS
and from 1.652, 1.636, and 1.794 for DOLS, respectively. Likewise, the expected
inflation as an opportunity cost variable and the real exchange rate both carry the expected
signs and are all highly statistically significant at 1% significance level except FMOLS
weighted estimates which are significant at 5% significance level.

The FMOLS and DOLS elasticity for the expected inflation is -0.004, -0.064, 0.006 and
-0.003, -0.002, 0.021 for pooled, weighted and grouped, respectively. These estimates are
in line with the theoretical literature. Expected inflation rate impacts the money demand
function negatively (in the case of the negative signs) whereby as and when the wealth
holders’ expectations about the future inflation rate is to raise further, they make changes
in their portfolio holdings by scaling down their liquidity through acquiring tangible
assets as a measure to avoid inflation tax. Therefore, the aggregate demand for real money
balances in the economy reduces. On the other hand, in case of grouped estimators above,
the coefficients are positive and highly significant at 1% level. In this case, subject to
their expectations and interpretations of the current and the future inflation rate. Most
common interpretation is that as money loses its value, more of it is demanded to
compensate its lost purchasing power (Mahmood & Asif, 2016).

Real expected exchange rate elasticity obtained from the two methodologies are equally
in conformity with the existing literature. All the estimates carry a negative sign and
therefore are particularly in line with the currency-substitution hypothesis (Calvo et al.,
1995).The implication here is that in all the countries under study, the demand for real
money balances (domestic currency) decreases following expected further depreciation
(increase in the exchange rate) in their respective domestic currencies. It also implies that
that the wealth-effect hypothesis developed by Komárek and Melecký (2001) is
overshadowed by the currency-substitution hypothesis across the Muslim majority
countries under study.
 192

Table 6.11. Results of panel estimation of cointegrating regression coefficients under

interest-based monetary policy (IBMP)
FMOLS DOLS

Cointegrating
regression Pooled Weighted Grouped Pooled Weighted Grouped
LGDP 1.410* 1.386* 1.368* 1.342* 1.400* 1.192*
(0.050) (0.009) (0.055) (0.062) (0.009) (0.055)
INFLNEX -0.007* -0.105* -0.004n -0.006* -0.110* -0.004n
(0.001) (0.025) (0.002) (0.001) (0.025) (0.002)
LEX -1.010* -0.797* -0.778* -0.739** -0.706* -0.854*
(0.224) (0.020) (0.167) (0.319) (0.020) (0.167)
Note: In FMOLS and DOLS (Pooled), estimation coefficient of covariance was computed using sandwich
method. Numbers in the parenthesis indicate standard error. Subscripts *, ** and *** indicate 1%, 5%
and 10% significance levels respectively while n signifies non-significant coefficient results.

Table (6.11) above summarises the results of estimations under the interest-based
monetary policy (IBMP) system, where the monetary aggregate employed is interest-
based; M2/IBMP. The regression coefficient results possess the expected signs. That is
the estimated coefficients are in line with the existing monetary theories since both the
scale variable and the opportunity cost variable carry the expected signs under both
FMOLS and DOLS regression models. Income positively impacts the money demand,
and its coefficients are 1.410, 1.386, 1.368 for FMOLS and 1.342, 1.400, and 1.192 under
DOLS for pooled, weighted and grouped panel estimates, respectively. These results are
all highly significant at 1%.

The expected inflation rate outcomes are also statistically highly significant at 1% and
carry a negative sign except for grouped panel results for both FMOLS and DOLS which
carries a negative sign but statistically insignificant. The coefficient estimates are as
follows; -0.007, -0.105, -0.004n under FMOLS and -0.006, -0.110, -0.004n under DOLS
for pooled, weighted and grouped panel estimates, respectively. The nonsignificant
coefficient for the expected rate of inflation may be interpreted to re-affirm the relatively
less role that expected inflation plays as an independent variable as mentioned earlier.

The real expected exchange rate carries a negative sign and statistically highly significant
at 1% except the pooled and grouped panel estimates under the DOLS approach both of
which are mildly significant at 10% significance level. The estimated coefficients here
 193

include -0.727, -0.496, -0.817 under FMOLS and -0.540, -0.434, -0.526 under DOLS for
pooled, weighted and grouped panels, respectively. The EX cointegration results are in
conformity with the currency-substitution hypothesis which implies that economic agents
or the public in these Muslim majority countries demand less of the domestic currency
and more of the international currencies especially the US dollars as the former
depreciates. This is because, as rational agents, their expectations of the future rate of
exchange is to increase more (further future increase in exchange rate). So, they draw
down on their demand for the domestic currency.

Conclusively, the panel data regression results above have three main implication i) re-
affirm the existence of long-run relationships (cointegration) between the dependents and
the independent variables considered in our money demand functions, ii) imply that that
expected inflation as an independent variable is more important under the Islamic
monetary economy compared to the conventional one and lastly iii) although both models
seem to be stable with coefficients of the scale variable and opportunity cost variable
carrying the expected signs, the model in which the interest-free monetary aggregate is
specified performs better since all the variables do not only possess the expected signs
but are also statistically significant than the one of interest-based monetary aggregate.

Having analysed cointegration in the panel data set, we now turn to individual cross-
sections to estimate the long-run cointegration coefficients using the same two
approaches before turning to the ARDL model for the short-run analysis. According to
Pedroni (2001), co-integration regression tests under the panel data is not straightforward
and this justifies the inclusion of specific country co-integration tests.

Table (6.12) below shows the elasticity and semi-elasticity coefficients of the money
demand function under the interest-free monetary system for all the countries in the
analysis in the long-run period. The outcomes of the estimates indicate clearly that money
demand is positively affected by the real GDP at 1% significant level for all the countries
of the study. These results are equally in conformity with the monetary theory literature,
in that a change in economic activities following income fluctuations also causes
consequential changes in the money demand in an economy. In other words, without
interest rate in the money demand function, income remains the only factor that has a
very important influence on the demand for money. Income (GDP) elasticity ranges from
0.12 – 2.89 under the FMOLS approach and 0.15 – 3.29 under DOLS. Apart from Qatar
 194

which exhibits positive but inelastic results, income elasticity coefficients for all the
countries are above unity. The implication here is that Islamic central banks in these
countries can determine the optimum amount of money supply required to maintain
relative financial and monetary stability through effective assessment of the economic
activities based on rational expectations.

The semi-elasticity co-efficient for the expected inflation rate has mixed signs. While
Bahrain, Indonesia, and Saudi Arabia coefficients possess positive signs and are all
significant at 1% except for Bahrain which exhibits non-significant estimates under the
FMOLS approach, Malaysia, Kuwait, Qatar, and Pakistan all exhibit negative signs.
Similarly, all these co-efficient are statistically significant at 1% level except for Malaysia
which possesses non-significant results. Under DOLS, however, Bahrain, Malaysia,
Indonesia, and Qatar all have positive coefficients and are statistically significant except
for Qatar. The implication here is that under an interest-free monetary aggregate, in case
of Indonesia and Saudi Arabia, Malaysia and Bahrain, expected inflation re-enforces
demand for more money as their respective domestic currencies lose purchasing power.
The effect is insignificant in Qatar.

The semi-elasticity coefficients range from -0.0021 – 0.05 under FMOLS and -0.001 –
0.13 under DOLS. This is in line with macroeconomic theories whereby in case of the
positive coefficients, as inflation increases more money is demanded not only to
compensate the loss of purchasing power of the national currency but also to facilitate the
increased transactions as wealth holders buy more attractive real assets in response to
higher asset prices. The increased investment in real assets in comparison to financial
assets as inflation surges is known as a substitution-effect (Friedman, 1988).

On the other hand, the negative coefficients imply that a rise in expected inflation rate
reduces money demand as wealth holders adjust in their wealth portfolios by reducing
their liquidity through acquiring more attractive real assets to hedge against inflation tax.
However, as asset prices increase further wealth owners demand more money to invest in
attractive real assets with higher prices (Nautz & Rondorf, 2011). This behaviour is
explained by the wealth effect hypothesis.
 195

6.15.2. Results for the long-run country specific estimations

The regression results under this section also follows the 5.3 and 5.4 based on Dynamic
OLS and Fully Modified OLS equations as specified earlier. The estimations are as
follows:

Table 6.12. Long-run country specific estimation of cointegration regression coefficients

under the interest-free monetary system (IFMP)
***FMOLS***under IFMP ***DOLS*** under IFMP
LGDP INFLNEX LEX GDP INFLNEX LEX
2.13* 0.00 -0.97* 2.36* 0.02* -0.10***
Bahrain
(82.69) (0.51) (-9.90) (160.85) (8.21) (-1.31)
1.60* -0.0021 -0.34* 1.88* 0.01* -1.12*
Malaysia
(51.52) (-0.62) (-4.86) (64.82) (5.40) (-14.11)
1.85* 0.05* 0.14 1.22* 0.13* 2.11*
Indonesia
(8.97) (5.30) (0.24) (5.96) (10.24) (3.42)
1.67* -0.01* 0.65* 1.75* -0.001 0.84*
Kuwaiti
(98.89) (-3.26) (9.93) (112.24) (-1.22) (7.55)
0.12* -0.01* -2.20* 0.15* 0.00 -1.49
Qatar
(2.22) (-7.60) (-10.76) (5.79) (1.13) (-8.60)
1.81* 0.01* -2.23* 2.12* 0.04* -3.84*
Saudi Arabia
(24.11) (3.65) (-5.47) (25.42) (8.00) (-7.50)
2.89* -0.01* -0.64* 3.29* -0.01* -0.50**
Pakistan (72.44) (-3.95) (-5.36) (32.14) (-2.60) (-2.47)
1.95* -0.001* 0.52* 1.74* -0.001* 0.61*
Turkey
(53.13) (-4.91) (7.76) (104.87) (-13.28) (14.39)
Note: In FMOLS and DOLS (Pooled), estimation coefficient of covariance was computed using sandwich
method. Numbers in the parenthesis indicate standard errors. Subscripts *, ** and *** indicate 1%, 5%
and 10% significance levels respectively while absence of these subscripts signify non-significant
coefficient results.

Lastly, the real expected exchange rate coefficients equally possess both negative and
positives under both approaches. While Bahrain, Malaysia, Qatar, Saudi Arabia, and
Pakistan exhibit negative coefficients under both FMOLS and DOLS, Indonesia, Kuwait,
and Turkey exhibit positive estimates. These results imply that whereas the wealth-effect
dominates over currency-substitution hypothesis in the latter group of countries,
currency-substitution hypothesis is dominant over the wealth-effect in the former. Both
 196

these effects are statistically significant in their respective economies except for Indonesia
and Qatar the positive and negative statistically insignificant values, respectively.

Under the interest-based monetary system, income equally positively and significantly
impacts money demand as shown by the positive coefficient values that range between
0.84 – 2.39 and 0.38 – 1.93 for FMOLS and DOLS approaches, respectively. However,
unlike the IFMP system where all the coefficients are greater than unity except for Qatar
in both approaches, the coefficients of income for Malaysia, Indonesia, Kuwait, and Qatar
are all less than unity under the interest-based system. Bahrain, Saudi Arabia, Pakistan,
and Turkey elasticity coefficients are greater than unity as summarised in the below.

Table 6.13. Long-run country specific estimation of co-integration regression coefficients

under the interest-based system (IBMP)
***FMOLS***Under IBMP monetary aggregate ***DOLS*** Under IBMP monetary aggregate
GDP INFLNEX LEX GDP INFLNEX LEX
1.75* -0.01* -0.51* 1.67* -0.02* -1.05*
Bahrain
(68.33) (-5.38) (-5.26) (62.04) (-5.23) (-7.54)
0.84* -0.001* -0.91* 0.38* -0.02* 0.27
Malaysia
(16.84) (-3.53) (-8.14) (2.99) (-3.32) (0.77)
0.97* 0.02* 0.35*** 0.61* 0.06*
Indonesia
(12.14) (4.83) (1.57) (5.61) (8.78) 1.10* (3.34)
0.96* -0.0021 -0.87* 0.93* -0.00 -1.16
Kuwaiti
(40.07) (-0.72) (-9.29) (105.40) (-1.22) (-18.42)
0.95* 0.0013** -0.99 0.92* 0.00 -0.99*
Qatar
(47.54) (2.23) (-13.55) (23.29) (1.01) (-7.97)
1.35* -0.01* -0.48** 1.60* -0.00 -2.19*
Saudi Arabia
(34.13) (-7.91) (-2.24) (23.98) (-0.91) (-5.36)
2.39* -0.01 -1.86* 1.93* -0.06 -5.59*
Pakistan (30.24) (-1.50) (-7.83) (7.09) (-5.90) (-9.32)
1.70* -0.001* 0.69* 1.50* 0.00* 2.79*
Turkey
(29.30) (-11.61) (6.56) (34.66) (7.99) (25.03)
Note: In FMOLS and DOLS (Pooled), estimation coefficient of covariance was computed using sandwich
method. Numbers in the parenthesis indicate standard error. Subscripts *, ** and *** indicate 1%, 5% and
10% significance levels respectively while absence of these subscripts signify non-significant coefficient
results.

Expected inflation rate negatively and significantly affects money demand for Bahrain,
Malaysia, Saudi Arabia, Pakistan, and Turkey under both the FMOLS and DOLS
 197

approaches. For Indonesia and Qatar, the effect is positive at 1% and 5% significance
levels. This is also in conformity with the monetary literature as explained under the
interest-free monetary system.

The real expected exchange rate under IBM system coefficients are negative and
significant for Bahrain, Malaysia, Kuwait, Saudi Arabia, and Pakistan. Indonesia and
Turkey possess a positive sign while Qatar exhibits a negative but non-significant result.
These estimates are under both approaches. This implies that while currency- substitution
hypothesis is dominant among the first group of countries, wealth-effect holds in the last
category. Having estimated the panel long-run money demand equations under the two
systems for the countries under study, we then estimated the dynamic short-run ARDL
model as follows:

6.15.3. Short-run coefficients estimated using ARDL model

The estimations and results analysis under this section is based on ARDL equations 5.10
and 5.11 for Islamic and conventional monetary systems, respectively. The table below
summarises the estimated cointegration tests based on the selected lag length of the
ARDL cointegration technique. Specifically, the optimum lag length, diagnostic tests, F-
statistics, serial correlation are all summarised as can be seen. The results show that
despite the short span range of our data period, long-run relationship (cointegration) have
been found in the Money demand function (MDF) of Malaysia, Kuwait, Saudi Arabia,
and Turkey under the interest-free monetary policy (LIFMP) framework at 5% and 1%
significance levels.
 198

Table 6.14. F-values based on ARDL model

Optimum
Dep.
Country lag F-stat Coint Decision Serial
Variable
selected corr.
Bahrain LIFMP (1,0,0,1) F-lifmp= 1.731 No Est ARDL (SR) 0.2067
LIBMP (1,0,0,0) F-libmp= 2.275 No Est ARDL (SR) 0.8088
Malaysia LIFMP (1,1,1,1) Flifmp= 5.044* Yes Est ecm (LR) 0.8517
LIBMP (1,0,1,0) Flibmp= 1.816 No Est ARDL (SR) 0.884
LIFMP (1,1,0,0) F-lifmp= 3.853 Yes Est ecm (LR) 0.1954
Indonesia
LIBMP (1,0,1,0) F-libmp= 2.167 No Est ARDL (SR) 0.1607
LIFMP (1,0,0,1) F-lifmp= 7.825* Yes Est ecm (LR) 0.3374
Kuwait
LIBMP (1,0,1,0) F-libmp= 5.169* Yes Est ecm (LR) 0.2719
LIFMP (2,0,0,1) F-lifmp= 1.108 No Est ARDL (SR) 0.5247
Qatar
LIBMP (2,2,2,1) F-libmp= 5.766* Yes Est ecm (LR) 0.3226
LIFMP (1,0,1,0) F-lifmp= 5.471* Yes Est ecm (LR) 0.5429
S.Arabia
LIBMP (2,0,1,0) F-libmp= 3.665 No Est ARDL (SR) 0.373
LIFMP (1,1,1,0) F-lifmp= 4.615 Yes Est ecm (LR) 0.3781
Pakistan
LIBMP (1,1,1,0) F-libmp = 2.108 No Est ARDL (SR) 0.4448
LIFMP (1,0,0,0) Flifmp= 5.044* Yes Est ecm (LR) 0.5772
Turkey
LIBMP (1,0,1,0) Flibmp= 1.816 No Est ARDL(SR) 0.1978
The subscript * signify cointegration in the model and Est = Estimate. The critical values for determination
F-statistics is provided by eviews 10 from above 3.77, 4.35, 5.61 at 10%, 5% and 1% significance level
respectively.

On the other hand, when the interest-based monetary (IBM) aggregate is employed,
cointegration is only present for Kuwait and Qatar at 5% and 1% statistical significance
levels, respectively. Where cointegration was found, an error correlation model was
estimated before calculating serial correlation and plotting the CUSUM and CUSUM
square stability tests of the two models for each country. In case of no co-integration, only
the short-run coefficient estimation and diagnostic Breusch-Godfrey Serial Correlation
Lagrange multiplier test was done and followed by model stability tests using CUSUM
and CUSUM square for all the countries in this category. The details of these estimations
are as follows.
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Table 6.15.Short-run country specific estimation of cointegration regression coefficients

***ARDL***Under IFMP ***ARDL*** Under IBMP
S.Run ∆IFMP ∆GDP ∆INFEX ∆LEX ∆IBMP ∆GDP ∆INFEX ∆LEX Ecm (-1)
0.213 0.579 -0.0005 -0.203 0.093 0.663 0.0003 0.055
Bah.
(0.410) (-0.559) (0.925) (0.654) (0.707) (0.489) (0.951) (0.886)
0.006 0.417 -0.001 0.201 -0.027 0.602 -0.0013 -0.268 -0.33(0.13)
Mal.
(0.972) (0.576) (0.147) (0.485) (0.917) (0.200) (0.650) (0.304)
-0.110 1.469 0.002*** 0.450 0.195 0.501 0.0008 -0.107 -0.72(0.04)
Ind.
(0.684) (0.101) (0.061) (0.109) (0.405) (0.555) (0.568) (0.719)
0.927** 0.366 0.019 -1.721 0.995* 0.454*** 0.007*** 0.027 -1.34(0.01)
Kuw.
(0.052) (0.765) (0.297) (0.393) (0.005) (0.068) (0.068) (0.956) -1.38(0.00)
0.403*** 0.312 0.002 -1.148 0.293 0.437 -0.0001 -0.254 0.28(0,26)
Qat.
(0.085) (0.170) (0.381) (0.132) (0.308) (0.324) (0.970) (0.745)
1.136 -0.110 -0.001 -0.222 1.133* 0.943 -0.011** -1.262** -1.07(0.87)
S. A
(0.145) (0.862) (0.740) (0.582) (0.001) (0.138) (0.025) (0.016)
-1.054** 11.57 -0.033*** 0.132 0.149 0.704 0.003** 0.201 -1.59(0.24)
Pak.
(0.035) (0.156) (0.069) (0.943) (0.510) (0.385) (0.021) (0.537)
0.413*** 0.256 -0.001** 0.111 0.149 0.327 0.0003 0.032 -0.91(0.01)
Tur.
(0.099) (0.664) (0.059) (0.660) (0.519) (0.613) (0.775) (0.903)
Numbers in the parenthesis indicate probability values. Subscripts *, ** and *** indicate 1%, 5% and 10%
significance levels respectively while absence of these subscripts signify non-significant coefficient results.

After the long-run country specific elasticity discussion and analysis, the above table
discusses the short-run elasticity and semi elasticity of the money demand function
parameters. As already noted, unlike the long-run estimates that are based on the FMOLS
and DOLS, the short-run elasticity coefficients are based on the ARDL approach. Based
on the F-statistics values, 6 of the 8 countries show short-run cointegration under the
interest-free monetary aggregate. These include Malaysia (F-Lifmp = 5.04), Indonesia
(F-Lifmp = 3.85), Kuwaiti (F-Lifmp = 7.82), Saudi Arabia (F-Lifmp = 5.47), Pakistan (F-
Lifmp = 4.61) and Turkey (F-Lifmp = 5.04).

However, the estimated error correction model (ecm (-1)) results are not consistent with
the findings of the F-statistics mentioned above. Only 3 of the 6 countries lagged
coefficient values possess the expected signs: negative and significant results. These
include Indonesia (-0.724 (0.046)), Kuwait (-1.348 (0.016)), and Turkey (-0.919 (0.013)).
The other 3 countries ecm (-1) coefficients carry the expected negative sign but with
 200

insignificant p-values; Malaysia (-0.336 (0.13)), Saudi Arabia (-1.07 (0.87)) and Pakistan
(-1.59 (0.24)).

On the other hand, only 2 of the 8 countries exhibit short-run cointegration based on the
lagged values of the error correction model (ecm(-1)); Kuwait (-1.38 (0.00)) and Qatar
(0.28 (0,26)). From these results, on the ecm (-1) coefficient of Kuwaiti is significant and
possesses the expected negative sign which confirms a strong link between the dependent
and independent variables of the conventional money demand function. For Qatar, the
coefficient does only fail the significance test, it also carries a positive coefficient sign.
As for Bahrain, the results do not support any of the two monetary aggregates in the study.

As for the income, the short run elasticity under the interest-free monetary aggregate is
positive but insignificant for all the countries except Saudi Arabia whose coefficients are
both negative and non-significant. However, even those with positive coefficients, the
elasticity is all very low except for Pakistan (11.57) and Indonesia (1.46). The Expected
inflation rate semi-elasticity results possess both positive and negative signs which are all
insignificant except for Indonesia, Pakistan, and Turkey. Also, Real Expected Exchange
Rate results reveal both positive and negative semi-elasticity coefficients. However,
unlike the expected inflation rate, all the coefficients in this case are insignificant.

Under the interest-based monetary system, the coefficient results are not very different
from those discussed under the interest-free system. Apart from Kuwait whose elasticity
coefficient results are significant, income possesses positive and insignificant results for
the rest of the countries. Similarly, the expected inflation and exchange rate semi-
elasticity coefficients possess both negative and positive signs implying that the results
are in conformity with the monetary theory literature as discussed under the panel results.

6.15.4. Comparison of money demand function stability for the two systems using
plots of cumulative sum of recursive residuals and cumulative sum of squares of
recursive residuals

Controlling the monetary aggregates requires stability of the money demand function.
This is because, an unstable money demand function thwarts the monetary policy
transmission mechanism. This implies that without a stable money demand function, the
monetary authority’s powers ability to control and regulate money supply and general
 201

price levels is severely reduced. Therefore, monetary-policy makers are only able to
precisely lay down their operational, intermediate, and ultimate monetary targets if they
can properly specify the correct (stable) money demand function.

Using the results of the ARDL model above, the following section compares the relative
stability of the two monetary systems using both the plots of cumulative sum of recursive
residuals (CUSUM) and cumulative sum of recursive residuals (CUSUM SQ) for each
cross-section in the panel as illustrated below.

6.15.4.1. The plots of cumulative sum of recursive residuals and cumulative sum of
squares of recursive residuals

The tables 6.16 – 6.31 summarise the lag structure tests we conducted to determine the
lag intervals for each country for each of the monetary systems. Having employed annual
data, we limited the lags to a maximum of 2 lags and the appropriate lag structure for each
monetary system was determined based on the lowest value of Akaike Information
Criteria (AIC). Also, the tables show the diagnostic tests that we conducted using the
Breusch-Godfrey Serial correlation LM test. The null hypothesis of no serial correlation
could not be rejected from all the diagnostic tests conducted. This is indicated by the P-
values that are higher than 05%.

6.15.4.1.1. Bahrain

Table 6.16. Lag order selection used Akaike information criterion (AIC)
Lag LogL LR FPE AIC SC HQ
0 44.43878 NA 0.00202 -3.369898 -3.173556 -3.317809
1 49.90391 8.653122* 0.001397 -3.741992 -3.496565 -3.67688
2 52.36438 3.690713 0.001242* -3.863699* 3.569185* 3.785564*

Breusch-Godfrey Serial Correlation LM Test

F-statistic 1.825959 Prob. F (2,11) 0.2067
Obs*R-squared 5.483391 Prob. Chi-Square (2) 0.0645
 202

Figure 6.6. a under interest-free monetary policy aggregate (lifmp)

Plot of cumulative sum of recursive residuals Plot of cumulative sum of square residuals.

Table 6.17. Lag order selection used Akaike information criterion (AIC)
Lag LogL LR FPE AIC SC HQ
0 46.698 NA 0.001673 -3.558235 -3.361893 -3.50615
1 50.324 5.739891* 0.001349 -3.777001 -3.531574* -3.71189
2 51.514 1.785861 0.001334* -3.792883* -3.498369 3.714748*

Breusch-Godfrey Serial Correlation LM Test

F-statistic 0.216409 Prob. F (2,11) 0.8088
Obs*R-squared 0.832864 Prob. Chi-Square (2) 0.6594

Figure 6.7. b under interest-based monetary policy aggregate (libmp)

Plot of cumulative sum of recursive residuals Plot of cumulative sum of square residuals
 203

6.15.4.1.2. Malaysia

Table 6.18. Lag order selection used; Akaike information criterion (AIC)
Lag LogL LR FPE AIC SC HQ
0 52.82026 NA* 0.001005* -4.068355* -3.872013* -4.016266*
1 52.98377 0.258885 0.00108 -3.998648 -3.75322 -3.933536
2 53.10135 0.176361 0.001168 -3.925112 -3.630599 -3.846978

Breusch-Godfrey Serial Correlation LM Test

F-statistic 0.162263 Prob. F (2,15) 0.8517
Obs*R-squared 0.487067 Prob. Chi-Square (2) 0.7839

Figure 6.8. a. Under interest-free monetary policy aggregate (lifmp)

Plot of cumulative sum of recursive residuals Plot of cumulative sum of square residuals

Table 6.19. Lag order selection used Akaike information criterion (AIC)
Lag LogL LR FPE AIC SC HQ
0 32.71541 NA 0.005366 -2.39295 -2.196608 -2.340861
1 40.36308 12.10882* 0.003093* -2.946924* -2.701496* -2.881812*
2 41.12531 1.14334 0.00317 -2.927109 -2.632596 -2.848975

Breusch-Godfrey Serial Correlation LM Test

F-statistic 0.124304 Prob. F (2,16) 0.884
Obs*R-squared 0.351906 Prob. Chi-Square (2) 0.8387
 204

Figure 6.9. b. Under interest-based monetary policy aggregate (libmp)

Plot of cumulative sum of recursive residuals Plot of cumulative sum of sqaure residuals

6.15.4.1.3. Indonesia

Table 6.20. Lag order selection used Akaike information criterion (AIC)
Lag LogL LR FPE AIC SC HQ
0 703.5931 NA* 2.82e-27* -58.29943* -58.10308* -58.24734*
1 693.7356 -15.60771 6.98e-27 -57.39464 -57.14921 -57.32952
2 689.0969 -6.958037 1.12e-26 -56.92474 -56.63023 -56.84661

Breusch-Godfrey Serial Correlation LM Test:

F-statistic 1.811509 Prob. F (2,16) 0.1954
Obs*R-squared 4.246514 Prob. Chi-Square (2) 0.1196

Figure 6.10. a. Under interest-free monetary policy aggregate (lifmp)

15 1.6

10
1.2

5
0.8

0.4
-5

0.0
-10

-15 -0.4
2000 2002 2004 2006 2008 2010 2012 2014 2016 2000 2002 2004 2006 2008 2010 2012 2014 2016

CUSUM 5% Significance CUSUM of Squares 5% Significance

Plot of cumulative sum of recursive residuals Plot of cumulative sum of square residuals
 205

Table 6.21. Lag order selection used Akaike information criterion (AIC)
Lag LogL LR FPE AIC SC HQ
0 32.32636 NA 0.005543 -2.36053 -2.164188 -2.30844
1 41.75184 14.92367* 0.002755* -3.062653* 2.817225* 2.997541*
2 41.90361 0.227652 0.002971 -2.991967 -2.697454 -2.91383

Breusch-Godfrey Serial Correlation LM Test

F-statistic 2.070068 Prob. F (2,15) 0.1607
Obs*R-squared 4.975049 Prob. Chi-Square (2) 0.0831

Figure 6.11. b. Under interest-based monetary policy aggregate (libmp)

Plot of cumulative sum of recursive residuals Plot of cumulative sum of square residuals

6.15.4.1.4. Kuwait

Table 6.22. Lag order selection used Akaike information criterion (AIC)
Lag LogL LR FPE AIC SC HQ
0 8.818191 NA 0.039311 -0.401516 -0.205174 -0.349426
1 21.15686 19.53623* 0.015328* 1.346405* 1.100977* 1.281293*
2 21.74965 0.889181 0.01593 -1.312471 -1.017957 -1.234336

Breusch-Godfrey Serial Correlation LM Test

F-statistic 1.169015 Prob. F (2,15) 0.3374
Obs*R-squared 3.101546 Prob. Chi-Square (2) 0.2121
 206

Figure 6.12. a. Under interest-free monetary policy aggregate (lifmp)

Plot of cumulative sum of recursive residuals Plot of cumulative sum of square residuals

Table 6.23. Lag order selection used; Akaike information criterion (AIC)
Lag LogL LR FPE AIC SC
0 32.56885 NA 0.005432 -2.380738 -2.184395
1 48.78624 25.67752* 0.001533* -3.648853* -3.40342*
2 48.8746 0.132551 0.001662 -3.572884 -3.27837

Breusch-Godfrey Serial Correlation LM Test

F-statistic 1.422352 Prob. F (2,15) 0.2719
Obs*R-squared 3.666533 Prob. Chi-Square (2) 0.1599

Figure 6.13. b. Under interest-based monetary policy aggregate (libmp)

Plot of cumulative sum of recursive residuals Plot of cumulative sum of square residuals
 207

6.15.4.1.5. Qatar

Table 6.24. Lag order selection used: Akaike information criterion (AIC)
Lag LogL LR FPE AIC SC HQ
0 23.08196 NA 0.011975 -1.590163 -1.393821 -1.538074
1 36.04892 20.53102 0.004431 -2.58741 -2.341982 -2.522298
2 39.05593 4.510516* 0.003766* -2.754661* -2.460147* -2.676526*

Breusch-Godfrey Serial Correlation LM Test:

F-statistic 0.684323 Prob. F (2,11) 0.5247
Obs*R-squared 2.434399 Prob. Chi-Square (2) 0.2961

Figure 6.14. a. Under interest-free monetary policy aggregate (lifmp)

Plot of cumulative sum of recursive residuals Plot of cumulative sum of square residuals

Table 6.25. Lag order selection used: Akaike information criterion (AIC)
Lag LogL LR FPE AIC SC HQ
0 32.56885 NA 0.005432 -2.380738 -2.184395 -2.328648
1 48.78624 25.67752* 0.001533* 3.648853* 3.403425* 3.583741*
2 48.8746 0.132551 0.001662 -3.572884 -3.27837 -3.494749

Breusch-Godfrey Serial Correlation LM Test

F-statistic 1.269605 Prob. F (2,10) 0.3226
Obs*R-squared 4.455036 Prob. Chi-Square (2) 0.1078
 208

Figure 6.15. b. Under interest-based monetary policy aggregate (libmp)

Plot of cumulative sum of recursive residuals Plot of cumulative sum of square residuals

6.15.4.1.6. Saudi Arabia

Table 6.26. Lag order selection used: Akaike information criterion (AIC)
Lag LogL LR FPE AIC SC HQ
0 39.49159 NA 0.003051 -2.957633 -2.761291 -2.905543
1 59.36145 31.46060* 0.000635* -4.530121* 4.284693* 4.465009*
2 59.73209 0.555961 0.000672 -4.477674 -4.183161 -4.399539

Breusch-Godfrey Serial Correlation LM Test

F-statistic 0.386593 Prob. F (1,16) 0.5429
Obs*R-squared 0.542616 Prob. Chi-Square (1) 0.4614

Figure 6.16. a. Under interest-free monetary policy aggregate (lifmp)

Plot of cumulative sum of recursive residuals Plot of cumulative sum of recursive residuals
 209

Table 6.27. Lag order selection used Akaike information criterion (AIC)
Lag LogL LR FPE AIC SC HQ
0 24.61708 NA 0.010537 -1.71809 -1.521747 -1.666
1 44.45067 31.40319 0.0022 -3.287556 -3.042128 -3.222444
2 48.63098 6.270472* 0.001696* -3.552582* -3.258069* -3.474447*

Breusch-Godfrey Serial Correlation LM Test

F-statistic 1.09002 Prob. F (2,10) 0.373
Obs*R-squared 3.937661 Prob. Chi-Square (2) 0.1396

Figure 6.17. b. under interest-based monetary policy aggregate (libmp)

Plot of cumulative sum of recursive residuals Plot of cumulative sum of square residua

6.15.4.1.7. Pakistan

Table 6.28. Lag. order selection used Akaike information criterion (AIC)
Lag LogL LR FPE AIC SC HQ
0 16.78135 NA 0.020245 -1.065112 -0.86877 -1.013023
1 23.03659 9.904128* 0.013105 -1.503049 -1.257621* -1.437937*
2 24.14615 1.664347 0.013047* -1.512179* -1.217666 -1.434045

Breusch-Godfrey Serial Correlation LM Test:

F-statistic 1.063761 Prob. F (2,11) 0.3781
Obs*R-squared 3.565446 Prob. Chi-Square (2) 0.1682
 210

Figure 6.18. a. Under interest-free monetary policy aggregate (lifmp)

Plot of cumulative sum of recursive residuals Plot of cumulative sum of square residuals

Table 6.29. Lag order selection used Akaike information criterion (AIC)
Lag LogL LR FPE AIC SC HQ
0 50.71184 NA 0.001198 -3.892654 -3.696311 -3.84056
1 57.60852 10.91973* 0.000735* -4.384043* -4.138615* -4.318931*
2 57.67048 0.092939 0.000798 -4.305873 -4.01136 -4.22774

Breusch-Godfrey Serial Correlation LM Test

F-statistic 0.611922 Prob. F (1,17) 0.4448
Obs*R-squared 0.799129 Prob. Chi-Square (1) 0.3714

Figure 6.19. b. Under interest-based monetary policy aggregate (libmp)

Plot of cumulative sum of recursive residuals Plot of cumulative sum of square residuals
 211

6.15.4.1.8. Turkey

Table 6.30. Lag order selection used Akaike information criterion (AIC)
Lag LogL LR FPE AIC SC HQ
0 33.96585 NA 0.004835 -2.49715 -2.30081 -2.445064
1 43.88622 15.70726* 0.002306* -3.240519* -2.995091* -3.175406*
2 44.39376 0.761308 0.002414 -3.19948 -2.90497 -3.121346
Breusch-Godfrey Serial Correlation LM Test:
F-statistic 0.567633 Prob. F (2,17) 0.5772
Obs*R-squared 1.502397 Prob. Chi-Square (2) 0.4718

Figure 6.20. a under interest-free monetary policy aggregate (lifmp)

Plot of cumulative sum of recursive residuals Plot of cumulative sum of square residuals

Table 6.31. Lag order selection used Akaike information criterion (AIC)
Lag LogL LR FPE AIC SC HQ
0 32.71541 NA 0.005366 -2.39295 -2.196608 -2.34086
1 40.36308 12.10882* 0.003093* -2.946924* -2.701496* -2.881812*
2 41.12531 1.14334 0.00317 -2.927109 -2.632596 2.84898

Breusch-Godfrey Serial Correlation LM Test:

F-statistic 1.796411 Prob. F(2,16) 0.1978
Obs*R-squared 4.217611 Prob. Chi-Square (2) 0.1214
 212

Figure 6.21. b. Under interest-based monetary policy aggregate (libmp)

Plot of cumulative sum of recursive residuals Plot of cumulative sum of square residuals

From above plots, the straight lines represent the critical bounds at 5% level of
significance. The blue line represents the statistics of the model parameters. When the
statistics stays within the critical bounds, it indicates the stability of the money demand
function for the specified monetary aggregate and monetary system. On the other hand,
the movement of the statistics outside the critical bounds implies that the money demand
function under that monetary aggregate and system.

In conclusion, apart from the Indonesian plot of cumulative sum of recursive residuals
for both IBMP aggregate, and Kuwait IFMP that experienced some transitional drifts, all
the recursive residual tests reveal that both models are stable and therefore the monetary
authorities in these countries should abandon interest-based system for the interest-free
aggregates such as the M1 for the overwhelming theoretical advantages over the
conventional as laid down in the theoretical section. The next section examines the
volatility of money under the two systems with a view to identifying the more stable
money.

6.16. Comparison of the variance of velocity of money under the two monetary
systems

Across macroeconomic literature, the fundamental role of velocity of money is

emphasised (Thornton, 1983). As already defined, velocity refers to the average number
of times a unit of money (M) exchanges hands in the transaction (T) process. The
behavioural tendencies of velocity of money carry profound implications for the general
performance of any economy (Darrat, 1988). The main implication that is drawn from the
 213

quantity theory of money as explained in chapter five an increase in money supply can
only be transmitted to an increase in prices or production only if velocity of money is
predictable (stable).

For monetary policy management, money supply as an instrument of monetary policy can
only become an effective tool under conditions of temporal stability in the velocity of
money. In other words, without a well-behaving (stable) velocity of money, monetary
policy actions may turn out to be spurious and a source of overall financial and economic
instability in an economy, contrary to the main goal of any monetary authority. Since the
velocity exemplifies the relation between money, price level and the level of output,
testing for the stability of velocity usually implies testing for the stability of the linear
relationship between money, price level and the level of output which is basically the
demand for money function (Bahmani-Oskooee & Karacal, 2007).

Therefore, this sub-section examines the velocity of money under the interest-free and
interest-based money. The aim here is to compare the stability of the two monetary
aggregates on the assumption that the monetary authorities have full control on the money
supply against the available evidence in the Muslim majority countries. The results in this
section are based on Fisher’s (1911) equation of exchange stated as follows.

∗ (6.37)

Where, M = money stock, V= income velocity of money and Y= Aggregate income such
as Gross National Product (GDP). From equation (6.35) above, velocity is defined as
below.

(6.38)
 214

Table 6.31. Summary statistical results of velocity and the variance of velocity of
money under the two monetary systems
VIFMP VIBMP
Mean 2.54E+12 Mean 8.65E+10
Median 5.17E+08 Median 1.98E+08
Maximum 4.77E+14 Maximum 8.74E+11

Minimum 218.2787 Minimum 438.3705

Std. Dev. 3.38E+13 Std. Dev. 2.28E+11

Skewness 13.99757 Skewness 2.352284

Kurtosis 196.9565 Kurtosis 6.789199

Jarque-Bera 318423.8 Jarque-Bera 301.0507

Sum 5.05E+14 Sum 1.71E+13

Sum Sq. Dev. 2.27E+29 Sum Sq. 1.02E+25
Dev.
Var. 1.14 Var. 5.19

From the above table, the results of both the mean and the variance of velocity tests are
quite variant for the two monetary aggregates (1.14) versus (5.20) for interest free money
against interest-based money, respectively. The above results are quite consistent with
theoretical postulations that interest-free monetary aggregate is relatively more stable as
compared to money with interest-based monetary aggregate. Earlier works by Hassan
and Aldayel (1998) (1998) and Darrat (1988), Akia and Darrat (2007) and had found
similar results.
The implication here is that central banks can regulate monetary policy more effectively
under the interest-free money as compared to money with interest. Although money plays
a passive role in the economy as a public good, with a stable income velocity of money,
the monetary authorities can influence economic activities towards the desired goals. In
other words, the monetary authorities under the Islamic economic order can increase the
aggregate demand levels through monetary policy fine-tuning. Under the interest-based
system, the speculative tendences caused by interest rate differentials compromise the
effectiveness of monetary policy fine-tuning. This is augmented by the relatively higher
variance of income velocity of money as stated above.
 215

However, to be successful in its policy regulations, there must be a strong correlation

between policy actions and the pace of economic activities that is augmented by relatively
more stable variance of velocity of money. The link between monetary aggregate and
monetary base ought to be not only strong but also reliable. The next section explores and
compares this link for the two financial aggregates and the monetary base.

6.17. The correlation between monetary aggregates and the monetary base

According to Batten and Thornton (1983), for the central bank to pursue monetary policy
objectives effectively and efficiently, its monetary and or financial aggregate must satisfy
two key conditions; 1) the monetary aggregate has to be under the direct and full control
of the central bank; 2) there has to be a strong and reliable co-integration between the
monetary aggregate and the main goals of the monetary authority. If only one of the two
conditions is satisfied but the other is not, then the effectiveness and superiority of the
monetary aggregate ceases to exist (Hassan & Aldayel, 1998).

Therefore, to assess and compare the relative effectiveness and superiority of interest-free
versus interest-based monetary aggregates from the monetary policy standpoint, we
investigated the above two conditions. On the monetary authority controllability over the
financial and monetary aggregate in the monetary policy management process, the
following equations have been estimated.

LIFMP a LMB e (6.39)

LIBMP a LMB e (6.40)

Where LIFMP M1 (proxy for the Islamic monetary policy aggregate), LIBMP M2
(proxy for the conventional monetary policy aggregate), a constant, LMB
monetary base, and e white noise error term with zero mean. When the correlation
between the monetary aggregate and the monetary base is stronger, the monetary
authorities possess more and direct control on the financial aggregate in question, the
central bank can effectively adjust the money stock as a reliable policy indicator to
achieve the desired macroeconomic goals including lower employment levels, sustainable
stable price levels, and increased incomes extra. The above two equations that represent
the two different monetary systems are regressed as follows.
 216

Table 6.32. The correlation between monetary aggregates and monetary base
Log of dependent Log of monetary R-squared Adj. R-squared
variable. base (MB) (R2) (R2. adj.)
Approach
FMOLS
Pooled IFMP 0.618 0.985 0.984
Weighted IFMP 0.596 0.985 0.984
Grouped IFMP 0.677 0.402 0.402
DOLS
Pooled IFMP 0.634 0.988 0.986
Weighted IFMP 0.701 0.988 0.986
Grouped IFMP 0.679 0.400 0.400
FMOLS
Pooled IBMP 0.515 0.983 0.983
Weighted IBMP 0.498 0.984 0.983
Grouped IBMP 0.744 0.342 0.344
DOLS
Pooled IBMP 0.754 0.588 0.548
Weighted IBMP 0.751 0.588 0.548
Grouped IBMP 0.738 0.348 0.284

As can be seen in the table, following the pooled, weighted and grouped categories under
the two approaches, the coefficient elasticity of IFMP aggregate ranges from 0.60% -
0.70%. On the other hand, IBMP aggregate coefficient elasticity seem more variant and
range from 0.49% - 0.75%. Whereas the regression was run using the three categories
under the two approaches, the comparison was based on DOLS (Grouped) as it is
considered super-consistent in small sample datasets and limited timespans as the case is
in our study (Foresti & Napolitano, 2013). Also, in relatively smaller samples, there are
relatively less distortions in the t-statistics of group-mean estimators. Therefore,
comparatively, group mean results are relatively robust and more acceptable (Pedroni,
2000).

The results show low correlation between the dependent variables (IFMP and IBMP) and
their respective independent variables (monetary base). The low statistical relationship
here resembles findings by Hassan and Aldayel (1998) whose study equally revealed very
 217

low correlation between interest-free and interest-based monetary variables. Therefore,

statistically, we fail to draw conclusive inference based on these findings.

Notably, however, the interest-free monetary aggregate seems to perform relatively better
than the interest-based monetary aggregate. That is 40% of IFMP is explained by the MB
as compared to only about 34% of IBMP explained by the MB. This weak explanatory
power of the independent variables could have been a result of model misspecification
(Darrat, 1988; Hassan & Aldayel, 1998).

To test the link between the monetary aggregate and the monetary policy goals, we
investigated the long-run relationship between the monetary aggregates and the consumer
price index (CPI). This is anchored on the fact not only traditionally but even in the
contemporary monetary economic theory, consensus has been built on sustainable price
stability and financial stability as the main goal for all the modern central banking
operations in any economy (Hossain, 2009, 2009, 2010). We thus estimated the following
equations.

LCPI LIFMP (6.41)

LCPI LIBMP (6.42s)

Where LCPI consumer price index as a function monetary aggregate LIFMP M1 for
equation (6.39) representing the interest-free financial and monetary system,
LIBMP M2 for equation (6.40) representing the interest based financial and monetary
system, a white noise error term, with constant variance and zero mean.
 218

Table 6.33. The correlation between price and monetary aggregate

Log of Estimated coefficients of R-squared Adjusted R-
dependent the independent variable (R2) squared
Approach variable
FMOLS LIFMP
Pooled LCPI 1.223* 0.395 0.370
Weighted LCPI 1.162* 0.396 0.371
Grouped LCPI 1.325* -53.74 -56.03
DOLS
Pooled LCPI 1.073* 0.666 0.595
Weighted LCPI 0.632* 0.638 0.561
Grouped LCPI 1.230* -45.06 -54.82
FMOLS LIBMP
Pooled LCPI 1.766* 0.521 0.501
Weighted LCPI 1.742* 0.521 0.501
Grouped LCPI 1.955* -76.06 -79.29
DOLS
Pooled LCPI 1.564* 0.617 0.536
Weighted LCPI 1.075* 0.592 0.505
Grouped LCPI 1.896* -82.90 -100.68
The subscript * signify that the coefficient in question is significant at 1% (percent).

From table (6.34), 45% variations in the price level (inflation) for the interest-free system
is explained by changes in the interest-free monetary aggregate (lifmp). In contrast,
changes in the interest-based monetary aggregate explains 83% of the variations in the
price level (inflation). Both the financial aggregates from their respective impacts on the
dependent variable possess the expected sign (positive) and are both highly significant at
1%. As can be seen, comparatively, the interest-based monetary aggregate as in model
(equation 6.40) in this case has more explanatory power of the dependent variable than
the interest-free one (equation 6.39). The higher explanatory power implies that the
interest-based monetary aggregate has a stronger link to the ultimate monetary policy goal
of sustainable price stability compared to the interest-free monetary aggregate. The results
here are consistent with an earlier study by Yousefi et al. (1997). This is not surprising
because, all the countries under study are running a monetary policy framework anchored
on interest rates
 219

In conclusion, however, once an Islamic monetary policy is undertaken, the strong link
in the interest-free based system implies that the central bank will possess more control
and powers to regulate monetary policy as compared to the debt-based system.

6.18. Study results, monetary policy implications and policy recommendations

This section summarizes the empirical findings of the study and makes the necessary
recommendations for policymakers and future research areas.

This study aimed at investigating the hypothesis that the Islamic monetary system is
superior and more effective over its conventional counterpart both theoretically and
empirically among the leading eight Muslim majority countries as indicated by their
Islamic finance asset shares (shown in brackets) including Saudi Arabia (31.70%),
Malaysia (16.70%), Kuwait (10.50%), Qatar (7.70%), Turkey (5.80%), Indonesia
(3.80%), Bahrain (1.70%), and Pakistan (1.20%). The most critical element of the
successfulness for any monetary policy action, both in the Islamic and the conventional
monetary system is the money demand function and its relative stability.

Therefore, this study assessed the general hypothesis that the Islamic monetary system is
more effective and superior over its conventional counterpart by comparing the relative
stability of the interest-free money (representing the Islamic monetary system) and the
interest-based money (representing the conventional monetary system) in a dual financial
system. The study followed the 04 (four) major questions raised in chapter one.

Under the theoretical analysis, the epistemological foundations for the postulation
showing the relative superiority, effectiveness, and efficiency of an interest-free financial
and monetary system in facilitating the achievement of macroeconomic goals especially
sustainable price and financial stability was examined. We cited several divine guidance
as the basis and foundation for a proper economic order which has guided mankind
throughout all passed generations as mentioned in the major divine scriptures including
the Holy Quran, the Bible, the Torah, and the traditions of Prophet Muhammad (PBH).

Following Ahmad and Ikram (2011) and Salim and Hassan (2019) studies, we
demonstrated how the Islamic monetary system facilitates the achievement of
macroeconomic goals in a more efficient and effective manner as compared to the
conventional system. This is because when fully operationalized, the economy under an
 220

interest-free monetary system operates at its optimal level (Ali, 2007; Nafik & Ryandono,
2007). At this level, not only is the monetary goal of sustainable price and financial
stability at high output level achieved but also the twin evils of macroeconomics; inflation
and unemployment as stressed in various studies including Liu and Rudebusch (2010),
Furuoka (2007), Zaman et al., (2011) among others are effectively solved as summarised
in equations (5.17) and (5.18).

For the above theoretical arguments to be augmented or to carry any meaningful

inferences, empirical estimations examining both monetary systems based on the money
demand function (MDF) was regressed using both and panel and time series FMOLS and
DOLS equations (6.3) and (6.4) to determine long-run relations between the dependent
and the independent variables. The short-run estimations were regressed using ARDL
equations (6.10) and (6.11).

Before running the regression, we tested for cross-section independence, stationary of the
variables, cointegration of the variables all of which are necessary steps to avoid spurious
estimates and misleading inferences. Based on the cross-section test results obtained
using Pesaran cross-section dependence (CD) and Pesaran scaled Langrage Multiplier
(LM), Pesaran (2004) among other tests, the null hypothesis of no cross-section
dependence was rejected. The existence of contemporaneous relationships among the
cross-sections implied that a combination of panel unit roots was necessary to test for
stationary of the variables.

On panel data sets, we employed the first-generation panel unit root techniques as well as
the second generational approaches. The first-generation panel techniques employed
include Levin, Lin, and Chu model (1992, 1993, and 2002) and I’m, Pesaran and Shin
(Pesaran et al, 1997, 1999, 2003) as per equations (6.12) and (6.15), respectively. Both
these techniques produce robust results because they possess higher power in small
samples as the case is in this study (Wagner & Hlouskova, 2010). We equally employed
second generation approaches that include Pesaran cross-section ADF (PESCADF),
equation (5.18) and Cross-section I’m Pesaran and Shin (CIPS) that take care of cross-
section dependence challenge (Baltagi & Pesaran, 2007).

Much as both categories of panel unit roots produced good estimates, we relied more on
the results of the second-generation unit root estimates (PESCADF and CIPS) due to the
 221

presence of cross-section dependence problem among the cross-sections. The

maintenance of results from both categories of unit roots is justified by the fact that
although the latter is recommended under contemporaneous correlation challenges that
are very common in the panel datasets, as a category, it is yet to develop fully especially
given the diversity of the potential cross-sectional correlations in panel data and therefore
it makes sense to maintain both results for comparison purposes (Hurlin et al., 2007).

The results for the unit root tests are quite different in that under the first-generation
category, variables exhibit mixed integration whereby while some are stationary at level,
others become stationary after first differencing. As for the second generation results,
variable comply with the sufficient condition requirement whereby they are all non-
stationary at level but all become stationary after being first differenced .However, as
expected the results from the second-generation techniques are more robust since these
approaches relax the assumption of cross-section independence (Chang, 2002). Similarly,
we tested for the unit root of the variables for each cross-section using Phillips-Peron
methodology (Phillips & Perron, 1988).

To estimate the equations (6.3), (6.4), (6.10) and (6.11) where the integrated variables
with different orders as revealed by the unit root tests, are involved, the existence of a
cointegration relationship should be present. Therefore, we conducted both panel and
individual cointegration tests to ascertain the existence of cointegration relationships. The
panel cointegration techniques used include Pedroni panel cointegration, Pedroni (2000),
Kao panel co-integration, Kao (1999) and Johansen & Fisher panel cointegration
(Maddala & Wu, 1999).

All the three approaches confirmed the existence of cointegration relationship among the
panel variables by rejecting the null hypothesis of no cointegration in case of panel A (the
Islamic monetary system panel) while two of the three techniques confirmed the existence
of panel cointegration among the variables in panel B (conventional monetary system
panel). For the individual cross-section we employed the F-values based approach based
on the ARDL model. This equally confirmed the existence of cointegration in each of the
cross-section variables except for Bahrain. The failure to find a long-run relationship
among Bahrain variables is attributed to the short span nature of our time series data
which makes such results less reliable.
 222

Upon satisfying all the above prerequisites for robust regressions, we estimated both the
panel and time series long run cointegrations using FMOLS and DOLS estimators as per
the equations (5.3 & 5.4) to determine whether the elasticity coefficient results and the
semi-elasticity coefficients of the variables in the models conform to the behavioural
economic theory as we answered our first general question. Whereas we estimated the
pooled, weighted and grouped categories of FMOLS and DOLS estimators, we relied our
analysis on the group-mean estimators especially of the DOLS estimator. This is because,
compared to the other categories, group-mean estimator’s t-statistics exhibit relatively
little distortions in small samples as the case is in this study. Therefore, inferences from
this category are considered more accurate and reliable (Pedroni, 2000).

In the first empirical estimations, the results for the panel long-run money demand
function regressions for both the interest-free money and interest-based money showed
that the elasticity coefficients conform to the behavioural economic theory. The estimates
of the scale variable are positive and significant at 1% level under both the Islamic and
the conventional monetary system. Under both systems, elasticity coefficients are above
unity; 1.794 and 1.192 for IFMP and IBMP, respectively. As economic activities increase,
more money is demanded under both systems (reversive causation as postulated by the
real business cycle theory).

Therefore, results obtained here collaborate the postulations by the real business cycle
theory whereby money supply changes responds to changes in the economic activities.
That is, if interpreted in terms of the money-output relations, money lags instead of
leading to economic activities. This implies a ‘reverse causation’ running from the
increases in economic activity causing an increase in demand and supply of money to
maintain a relatively stable inflation rate (Kydland &Prescot, 2008)

The opportunity cost variable elaticity coefficients of expected inflation rate are equally
in conformity with the existing macroeconomic literature. While the sign is positive under
the Islamic monetary system, it is negative in the interest-based system. The coefficient
is 0.021 (inelastic and positive) and highly significant at 1% for the interest-free system
and -0.004 (negative) but non significant. The results obtained on the opportunity cost
variable here collaborate those obtained by a related Mahmood & Asif (2016) study on
the GCC economies).
 223

The negative expected inflation rate coefficient may imply that the opportunity cost of
holding money as a motive plays a relatively minor role compared to the transaction
motive under the interest-based system (Komárek & Melecký, 2001). Moreover, the most
emphasised determinants of demand for money in the conventional economy are two,
income and the interest rate. Therefore, where interest rate is dropped as an important
variable, only income plays a significant role in determining the amount of money
demanded in an economy. This is especially true in developing countries where the choice
of asset holders is between money and goods as opposed to money and financial assets.
This is attributed to the existence of thin financial markets that are highly controlled by
monetary authorities (Hassan & Aldayel, 1998). Most importantly, it re-affirms the
monetary economic theory that economic agents prefer to change their portfolios into
asset holdings to avoid inflation tax as opposed to remaining liquid, thereby lowering the
demand for real money balances.

For the real expected exchange rate variable, the signs are also as expected. Under both
systems, the estimated coefficients carry negative signs; -0.526 and -0.854 for IFMP and
IBMP, respectively at a very high significance level of 1%. Therefore, for all the countries
under study, the currency-substitution hypothesis postulated by Calvo and Rodriguez
(1997) dominates over the wealth-effect hypothesis (Komárek & Melecký, 2001). In
other words, economic agents in these countries demand more foreign currencies such as
US dollars, Euros, extra, as their domestic currencies depreciate. A current period
depreciation creates higher future depreciation (foreign exchange rate increase), so
economic agents demand for domestic currency decreases.

The second empirical estimations focused on the long run cointegration regressions of the
individual member countries are not very different from the panel estimations in terms of
the expected signs of the coefficients. The scale variable possesses a positive sign, and
the opportunity cost variables possess mixed signs, implying that the estimates are in line
with the existing macroeconomic literature. However, these results could have been
influenced by the dominance of the conventional banking sector as pointed out in chapter
two. Therefore, the interpretation and inferences from these results ought to be made
cautiously.

The third empirical estimations focused on the short run cointegrating regression. After
confirming the expected signs for both the panel and the time series elasticity coefficients
 224

for all the variables, we regressed the short-term relationship using the ARDL model.
Based on the results obtained, we examined and compared the stability and consistency
of the money demand function under the Islamic monetary system and the conventional
system with a view to determine whether the interest-free monetary system is more stable
and therefore more effective compared to its interest-based monetary system counterpart.
Although we targeted short-run estimates for this model, the long run estimates were also
estimated using the error correction term (ECM).

In this regard, we investigated the plots CUSUM and CUSUM SQ tests. This
investigation was based on the summarised estimates in table (6.14). Based on F-
statistics, we first examined the existence of short-run relationships for each cross section
under each monetary system. Where the long-run relationship was not found due to the
short span nature of the annual data used, the CUSUM and CUSUM SQ plots were based
on the short-run estimates only as summarised in table (6.14)

Where the long-run cointegration exists, we investigated the error correction term (ecm
(-1)) whose coefficient was expected to be negative and significant to confirm the
existence of long-run stable state (cointegration) between the dependent and the
independent variables in the money demand function for the cross-sections in question.
Under the interest-free monetary regime (IFMP), apart from Bahrain, all the countries
possessed an ecm (-1). However, only Indonesia, Kuwait and Turkey return to their long-
run stable state since their coefficients are negative and significant at 5% for Indonesia
and 1% for Kuwait and Turkey. Their speeds of adjustment to the long-run stable state
are 72%, 13.3% and 91%, respectively. For Malaysia, Saudi Arabia, and Pakistan their
ecm coefficients are negative but non-significant. Qatar’s ecm (-1) is both positive and
insignificant. This bad result is attributed to the short span nature of our annual dataset
since ARDL models works better when the time series exceeds 30 observations. On the
other hand, under the interest-based regime, only Kuwait possess a long-run co-
integration link. Its speed of adjustment to the long-run stable state is 13.8%.

The fourth empirical part focused on comparing the relative stability of the money
demand function for both interest-free and interest-based monetary aggregates, apart from
the Indonesian plot of cumulative sum of squares for the recursive residual’s tests tests
for both IBMP aggregate, and Kuwait IFMP that exhibited some transitional drift beyond
 225

the critical regions, all the other plots show that both models are relatively stable since
they lie within the 5% critical region.

Our study results again collaborate the findings from the study by Hassan and Aldayel
(1998) who analysed the behaviour of demand for money under interest-free and interest-
based financial systems in fifteen Muslim countries. In both studies, the results fail to find
overwhelming empirical support for the hypothesis that the money demand function
under the interest-free monetary system is more stable as compared to that of interest-
based system. So, our findings concerning the stability of the money demand function
(MDF) contrast earlier studies by Darrat (1988) on the Tunisian economy and the most
recent works of Awad & Soliman (2016) who compared the Egyptian (conventional
system) and Iranian (Islamic system) the basis of the money demand function stability.

Both studies found overwhelming empirical support for the hypothesis that the money
demand function (MDF) under an Islamic economy is stable and unstable under the
conventional system. Our failure to find overwhelming support could have been because
of both the dominance of the conventional banking sector across these countries as
showed in chapter three and the continued implementation of monetary policy based on
the conventional policy tool, the interest rate.

Most importantly, however, the relative stability of both the monetary aggregates under
both systems implies that the money supply can be employed as an effective monetary
policy tool. This is in line with the suggestion laid down by Poole (1970, 2006) who
argued that where a stable money demand function exists, the central bank can employ
money supply as an effective monetary policy tool. So, monetary authorities under dual
monetary and financial systems should consider starting to employ money supply as
defined in this study for the respective monetary system as opposed to continuing to rely
on interest rate which compromises the maqsid shari’ in those economies.

The maximum lag selection was done automatically using Akaike information criterion
(AIC) and using Breusch-Godfrey Serial Correlation LM test technique, the null
hypothesis of existence of serial correlation from the residual diagnostic tests, was
rejected for all the countries as indicated by the higher p-values which are more than 5%.
The serial correlation results, F-value statistics and the maximum lags selected per
estimation are shown in tables (6.16 - 6.30).
 226

The fifth empirical part compared the variance of velocity for the monetary aggregates
under the two monetary systems, the results for the variance of velocity tests are quite
variant for the two monetary aggregates (1.14) versus (5.20) for interest-free money stock
against interest-based money stock, respectively. These results are quite consistent with
theoretical postulations in the Islamic monetary literature; that’s money with no interest
is more less volatile as compared to money with interest that is anchored on speculations
based on interest rate differentials in different areas. Earlier works by Hassan and Aldayel
(1998) and Darrat (1988), Yousef et, al. (2010), among others had found similar results.
So, our findings do not only appear consistent with the theoretical postulations and
expectations but also augment and collaborate with earlier studies as cited above.

The implication here is that central banks in Muslim majority countries can regulate
monetary policy more effectively and efficiently under the interest-free money (M1) as
compared to money with interest (M2). However, this effectiveness and efficiency in
monetary management ought to be anchored on the existence of not only a monetary
aggregate over which the monetary authority possess full control but also a strong and
reliable link between the financial / monetary aggregate and the goal of monetary policy,
sustainable price, and financial stability.

Lastly, we empirically investigated and compared the statistical relationships between the
monetary aggregate and the monetary base for each monetary system, plus the link
between the ultimate monetary goal and the monetary aggregates. In the first regression,
results show low correlation between each of the two dependent variables (IFMP and
IBMP) and the independent variable (monetary base). The low correlation result here
collaborates findings by Hassan and Aldayel (1998) whose study equally revealed very
low correlation between interest-free and interest-based monetary variables and the
monetary base.

Most importantly, however, the interest-free monetary aggregate seems to perform

relatively better than the interest-based monetary aggregate. That is 40% of IFMP
variation is explained by the changes in MB as compared to only about 28% of IBMP
explained by the MB. This weak explanatory power of the independent variables could
have been a result of model misspecification of the model such as omission of an
important independent variable. Like their elasticity coefficients, both these results are
 227

highly significant at 1% level. So, in general terms, the IFMP aggregate-monetary base
nexus seems relatively stronger as compared to the IBMP aggregate-monetary base as
evidenced from the 40% and 28% values for the former and the latter, respectively.

This relatively strong link in the interest-free based system implies that the central bank
has more control and powers to regulate monetary policy as compared to the debt-based
system. This is further augmented by the inexistence of the fractional banking
requirement which offers the monetary authority full control on the money supply since
the commercial banks cannot create money. But, from table (6.34) the relatively stronger
link between the ultimate monetary policy goal (sustainable price and financial stability)
and the monetary aggregate of the interest-free monetary system compared to the interest-
based system is contradicted. The empirical results are consistent with the findings of
Yousefi et al., (1997) who found a stronger link between the interest-based monetary
aggregate as opposed to Darrat’s (1988) study that had concluded that the link is stronger
between the interest-free monetary aggregate and the monetary policy goal.

6.19. Summary of findings and recommendations

In this study, we theoretically and empirically examined the hypothesis that the monetary
policy management through the Islamic central banking system or framework is more
effective, efficient, and superior over the conventional one.

From the theoretical analysis, the epistemological foundations for the postulations
showing the relative superiority, effectiveness, and efficiency of an Islamic monetary and
financial system, characterised by interest-free banking and financial practices in
facilitating the achievement of macroeconomic goals especially sustainable price and
financial stability was examined. The study referred to several citations from divine
guidance as the basis and foundation for a proper economic order which has guided
mankind throughout all passed generations as mentioned in the major divine scriptures
including the Holy Quran, the Bible, the Torah, and the traditions of Prophet Muhammad
(PBH).

Following Ahmad and Ikram (2011) and Salim and Hassan (2019) studies, we
demonstrated how the Islamic monetary system facilitates the achievement of
macroeconomic goals in a more efficient and effective manner as compared to the
 228

conventional system. From the theoretical analysis, the study concluded that when fully
operationalized, the economy under an interest-free monetary system operates at its
optimal level, collaborating earlier studies in the area of Islamic economics such as Ali
(2007) and Nafik & Ryandono (2007). So, a fully-fledged Islamic monetary policy
framework does not only facilitate the achievement of monetary policy goal of sustainable
price and financial stability at high output level but also effectively solves the “twin evils”
of macroeconomics; inflation and unemployment as summarised in equations (5.17) and
(5.18).

Further still, our theoretical findings re-affirms that whether Islamic or conventional
monetary arrangement, the main aim of central banks’ monetary policy operations is to
achieve sustainable price and financial stability in an economy (Erdem et al., 2017;
Hossain, 2010,2015). To achieve monetary policy goals, central banks employ a
multiplicity of monetary policy tools including mudarabah, musharakah, ijarah under
the Islamic monetary system and discount rate, open market operations, fractional reserve
requirements among others for the conventional. So, dual economies ought to employ
both categories of instruments to avoid the temptation of dissolving a weaker system into
the dominant one. All the conventional tools which do not involve interest rate remain
valid under the Islamic monetary system although some modifications may be required
in some cases. For example, open market operations can strictly be anchored on profit
and loss sharing ratios of different contracts such as sukuk, qardh-hassan, mudarabah,
and musharakah among others.

However, to be able to accurately and precisely project and predict the amount of money
supply necessary to achieve the desired goal and the appropriate tools necessary, a stable
money demand function ought to be in existence in the economy (Doguwa et al., 2014;
Kia & Darrat, 2007; Ozturk & Acaravci, 2008; Poole, 1970, 2006). Across the Islamic
monetary and financial literature, both published and unpublished works of different
scholars, the performance of economic and financial institutions and the entire economy
in general can prosper with the absence of interest-rate charges. In fact, income inequality
and distributive social economic justice that is espoused by Islam can genuinely be
achieved relatively faster under an Islamic monetary and financial system. (Erdem, 2017).

Therefore, in the empirical section, we adopted and modified the restructured form of
Friedman’s (1956) model where the demand for money is considered as an extension to
 229

the theory of demand for durable goods. Replacing interest rate with the expected
inflation rate, the real demand for money balances is determined by real GDP (income)
as a scale variable, real expected inflation rate as a representative of the opportunity cost
and the real effective exchange rate variable. We employed the fully modified OLS and
Dynamic OLS methodologies, both of which are recommended when the panel data
contains contemporaneous correlation. Other justifications for using these two
approaches on the panel estimation section are FMOLS and DOLS combine
nonparametric approaches and white heteroskedastic standard error terms to produce very
robust estimates (Agacer et al., 2015; Arize et al., 2000).

In other words, each of these techniques can correct the long-run correlation challenges
among both the co-integrating equations as well as amongst the stochastic regressors.
Most importantly, in our analysis, we relied much on the DOLS estimation results
because, DOLS estimator is super-consistent and robust not only in case of an omission
of variables that do not form part of the cointegrating relationship such as interest rate but
also reducing the bias of small sample size, a feature which is peculiar to our study (Masih
& Masih, 1996).

As already highlighted, estimations (Tables 6.11 & 6.12) from the standard money
demand function in which real GDP (income) was our scale variable that measure the rate
of economic activities (transactions), expected inflation rate as the opportunity cost, plus
the real expected exchange rate variable all yielded results that are consistent with the
existing monetary and macroeconomic theory. While the scale variable has a positive
elasticity coefficient, implying that the demand for real money balances increases with
the increase in economic activities in an economy. The expected inflation rate as
opportunity cost variable carries mixed elasticity coefficient signs. In the case of the
negative sign, the impact on the money demand function is negative. Otherwise, it is
positive (Mahmood & Asif, 2016b).

The implication here is that as and when the wealth holders expect the inflation to raise,
they make changes in their portfolio holdings by reducing their liquidity through
acquiring tangible assets. Since this is aimed at avoiding inflation tax, the demand for real
money balances reduces. On the other hand, in case of grouped estimators above, the
coefficients are positive and highly significant at 1% level. In this case, an increase in
expected inflation increases the money demand balances. This equally conforms to the
 230

theory in that as money loses its value, more of it is demanded to compensate its lost
purchasing power (Mahmood & Asif, 2016).

Similarly, the real expected exchange rate elasticity results obtained from the two
methodologies are equally in conformity with the existing literature. All the estimates
carry a negative sign and therefore are in line with the currency-substitution hypothesis
(Calvo et al., 1995). The implication here is that economic agents demand less domestic
currency and more of the foreign currency as the former depreciates.

From the first empirical estimations, the results for the panel long-run money demand
function regression for both the interest-free money and interest-based money showed
that the elasticity coefficients conform to the behavioural economic theory (all possess
the expected signs). The estimates of the scale variable are positive and significant at 1%
level under both the Islamic and the conventional monetary system. Under both systems,
elasticity coefficients are above unity for the scale variable.

The opportunity cost variable elaticity coefficients of expected inflation rate are equally
in conformity with the existing macroeconomic literature. While the sign is positive under
the Islamic monetary system, it is negative in the conventional system. The coefficient is
0.021 (positive) and highly significant at 1% for the interest-free system and -0.004
(negative) but not significant. The negative coefficient under the interest-based system do
not only confirm Mundell (1963, P.484) study but also re-affirms the conventional
monetary theory that both income and interest rate play a significant role in determining
the demand for money. So, where interest is dropped from the model for the different
reasons mentioned earlier including avoiding multicollinearity with the expected inflation
rate (payne, 2003), not being an appropriate measure of opportunity cost compared to
inflation rate since its arbitrarily set by the monetary authorities especially in developing
countries (Bahmani-Oskooee & Rehman, 2005; Budina et al., 2006), it is only income
that remains the key determinant.

On the money demand function stability, although we could not overwhelming find
empirical evidence to support the hypothesis that the Islamic based money demand
function is more stable compared to its conventional counterpart, the relative stability of
both monetary aggregates under both systems when interest rate is not considered as part
of the independent variables implies that the money supply can be employed as an
 231

effective monetary policy tool under both systems. This is in line with the suggestion laid
down by Poole (1971, 2006) who argued that where a stable money demand function
exists, the central bank can employ money supply as an effective monetary policy tool.
So, monetary authorities under dual monetary and financial systems should consider
starting to employ money supply as defined in this study for the respective monetary
system as opposed to continuing to rely interest rate which compromises the maqsid
shari’ in those economies.

On testing the volatility and or variance of velocity of money for each monetary system,
the results are quite variant and clear. That is to say (1.14) versus (5.20) for interest-free
money against interest-based money, respectively. These results are quite consistent with
theoretical postulations in the Islamic monetary literature whereby money with no interest
is less volatile as compared to money with interest that is anchored on speculations based
on interest rate differentials in different areas. Earlier works by Hassan and Aldayel
(1998) and Darrat (1988), Soliman and Awad (2016), among others had found similar
results. So, our findings do not only appear consistent with the theoretical postulations
and expectations but also augment and collaborate with earlier studies as cited above.

On comparing the two monetary systems on their ability to effectively pursue monetary
policy, we tested each monetary aggregate on the two pre-conditions suggested by Batten
and Thornton (1983) whereby to qualify as an effective monetary policy objective, the
monetary aggregate should certify two criteria including; i) the monetary aggregate has
to be under the direct and full control of the central bank; ii) there has to be a strong and
reliable link between the monetary aggregate and the main goal of the monetary authority.

Under the Islamic monetary system, the monetary authority possesses direct and full
control on the interest-free monetary aggregate. This is anchored on the existence of the
100% reserve requirement and absence of the fractional reserve ratio. So, commercial
banks under the Islamic monetary arrangement cannot create derivative money and hence
the relative financial stability. Comparing the correlation between the interest-free
monetary aggregate and the monetary base as well as the link between the main monetary
policy goal (price stability) and the monetary aggregates, the interest-free monetary
exhibited a relatively stronger link compared to its interest-based counterpart.
 232

In conclusion, based on the findings of this study, an Islamic monetary system appears
relatively superior and destined to achieve its monetary policy goal more effectively
compared to the conventional one. Therefore, our study findings are hoped to augment
the belief and provide more confidence to monetary authorities in both these countries
and even in others to trigger a mindset and gradual practical shift towards the Islamically
acceptable monetary policy tool by replacing the policy rate with money supply.

6.20. Recommendation for further studies

As earlier stressed, monetary management is the most important segment of a

macroeconomic policy. Because of our inability to access actual Islamic banks data, we
only used proxies in our estimations. Therefore, more studies should be undertaken with
the actual Islamic banks and financial data from these countries to augment the findings
reached in this study.
 233

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RESUME

Name : ABUBAKAR
Sur name : BYANGO
Country : UGANDA
Date of Birth : 15TH JUNE 1983, JINJA-UGANDA
Marital status : MARRIED
Mobile contact : +905383790059 / +256701844318
Email address : byangoa@gmail.com
Address : Mevlana mahallesi cemil baba Caddesi 52/18 Tugragul
yapi Koop. Talas/kayseri
Education background

Level Institution Completion Year

Economics PhD Erciyes Üniversitesi

Masters (MMS/HRM) Uganda Management Instıtute 2015
PGDHRM Uganda Management Instıtute 2013
B.A. EDUC Islamic University in Uganda 2009
High school (U.A.C.E) Bugembe Islamic institute 2004
Ordinary level (U.C.E) Ahlul bait high school 2002

Work experience Institution Position

2009-2014 Shuhadae islamic institute Deputy H/T Academics

2015 (6months) Post Bank Uganda Banking officer

Foreign Languanges Level

English Advanced
Turkish Intermediate
Arabic Intermediate

Areas of interest

Monetary economics, Islamic economics, Human resource management, Education