Research Center for Islamic Economics and Finance

Universiti Kebangsaan Malaysia

Bangi 43600, Selangor, Malaysia
Fax: +603-89215789
http://www.ekonis-ukm.my
E-mail: ekonis@ukm.my

Working Paper in Islamic Economics and Finance No. 1006

Tools in Controlling Monetary Variables in Islamic Banking System

Abdul Ghafar Ismail1

International Shari’ah Research Academy for Islamic Finance
and
Research Center for Islamic Economics and Finance
Universiti Kebangsaan Malaysia
Bangi, 43600 Selangor D.E.,
Malaysia
Fax: +603-8921 5789
e-mail: agibab@ukm.my

Abstract

The prohibition from receiving and paying interest in Islamic banking system raises the question on
how the monetary policy would be conducted in the absence of interest, both as a tool of monetary
policy and also the choice of monetary variables to be controlled. In addition, the Islamic banking
system is designed on the principle of profit sharing or non-profit sharing. In the first model, there is
purely profit sharing principle on both assets and liabilities. In the second model, there is mixed of
profit sharing and non-profit sharing principles. The difference lies in the sharing of profit from both
models. Consequently, both models have implications for formulating the design and use of tools of
monetary policy.

JEL Classification: G2; K2; K4;

Keyword: monetary policy tools; monetary policy target; Islamic bank behaviour; full
reserves; profit sharing ratio;

1
Professor of banking and financial economics, School of Economics, Universiti Kebangsaan Malaysia. He is
also AmBank Group Resident Fellow for Perdana Leadership Foundation. This paper will be presented at the
International Conference on Islamic Finance, Universiti Malaysia Sabah, 18-19 March 2010
 2

1. Introduction

In monetary economics, monetary policy is an important public policy in managing the economy. The
Bank is given the task to conduct the monetary policy to promote monetary stability and financial
stability and hence, to produce a conducive environment to attain the sustainable growth of the
economy. In Malaysia, the financial system consists of the conventional financial system and the
Islamic financial system.2 The later is prohibited from receiving and paying interest. A question arises
as to how the monetary policy would be conducted in the absence of interest, both as a tool of
monetary policy and also the choice of monetary variables to be controlled.3 Especially, when interest
rate is used as a benchmark for Islamic financial transactions. For example, Choudhry and Mirakhor
(1996) and Masood Khan (2004) mentioned that interest rate become the basis of securities used for
open market operations.
The absence of interest, as mentioned by Mohsin and Mirakhor (1984), would not lead to any
dilution in the effectiveness of monetary policy to achieve its objective. However, the design of
Islamic banking system may change the transmission of monetary policy. This issue has not been
touched yet. Hence, the prohibition of interest not only raises the implication for the working of
monetary policy (including the financial system) in dual financial system but also the relations
between depositors-bank and bank-entrepreneur.
There remain questions about the choice of monetary policy tools. Basically, there are two
financial system designs, with both models relying on the principle of profit sharing or non-profit
sharing with depositors and entrepreneurs. In the first model, there is purely profit sharing principle
on both assets and liabilities. In the second model, there is mixed of profit sharing and non-profit
sharing principles. The difference lies in the sharing of profit from both models. Consequently, both
models have implications for formulating the design and use of tools of monetary policy.
The discussion of this paper will explain first the choice of monetary policy tools. It will be
followed by the discussion on theoretical basis for the concept of operational target of monetary
policy. In determining the target of monetary variables, both short-term interest model and reserve
position will be presented in sections 4 and 5, respectively. In section 7, the focus will highlight on the
lesson from reserve position doctrine. Finally, the suggestion on the choice of monetary target for
Islamic banking system will be forwarded in section 8.

2. Choice of Monetary Policy Tools

As part of formulating the monetary policy, which is normally described in textbook, the Bank has the
choice to use three tools: reserve requirements, overnight policy rate, and open market operation. The
aim of these tools is to promote monetary stability and financial stability which can produce a
conducive environment to attain the sustainable growth of the economy. And to achieve the objective,
the Bank establishes the monetary policy committee. The responsibility of this committee is in
formulating the monetary policy and the policies for the conduct of monetary policy operations. In the
following sub-section, the discussion will be focused on the working of each tool.

Reserve requirements

The statutory reserve requirement (SRR) is a monetary policy tool used by the Bank for the purposes
of liquidity management and for the contraction or expansion of financing in the Islamic banking
system. It has been implemented since January 1959. Effectively, Islamic banks and other banking

2
Please refer to the Bank of Malaysia Act (gazetted on September 2009 and after this is called as the CBA). The
Bank of Malaysia is also known as Bank Negara Malaysia. The interpretation 2(1) under the Act also mentions
that the “Central Bank of Malaysia” as Bank
3
Sometime, we can call this variable as intermediate target.
 3

institutions are required to maintain balances in their Statutory Reserve Accounts equivalent to a
certain proportion of their eligible liabilities (EL). This proportion is known as the statutory reserve
requirement rate. By changing the rate, the Bank can withdraw or inject liquidity in the Islamic
banking system to make up for excess liquidity or lack of liquidity.
In principle, Islamic banks must maintain their Statutory Reserve Accounts balances that are
at least equal to the prescribed ratio at the Bank. If Islamic banks fail to comply with the minimum
SRR requirement, they are liable to pay a penalty. Therefore, Islamic banks must observe the
movement of SRR. To fulfill this requirement, Islamic banks are required to maintain the average
daily amount of their eligible liabilities over a fortnightly period (the base period). Each month will
have two base periods (for example, Base Period A and Base Period B): Base Period A is the average
daily amount of EL from the 1st to the 15th day (inclusive); and Base Period B is the average daily
amount of EL from the 16th to the last day of the month (inclusive).
For the reserve maintenance period from the 1st to the 15th day of any month, the SRR will
be based on the average EL of Base Period A of the preceding month, while for the reserve
maintenance period from the 16th to the last day of any month, the SRR will be based on the average
EL of Base Period B of the preceding month.
However, maintenances of balances in the Statutory Reserve Accounts are flexible, with a
daily variation from the SRR within a band, which currently stands at ±20% of the prevailing
statutory reserve requirement ratio. This band, within which the balances of each Islamic bank are
allowed to fluctuate on any day, allows Islamic banks flexibility in managing their liquidity and at the
same time, to ensure that no Islamic bank behaves imprudently by allowing their reserves on any
given day to fall too far.
While, the components of EL consists of ringgit denominated deposits and non-deposit
liabilities, net of inter-bank assets and placements with the Bank. As of 1 September 2007, additional
adjustments were made to the EL component:4
Exclusion from EL components:
- the entire proceeds of Tier-1 housing financings/financing sold to Cagamas Berhad.
- 50% of the proceeds of Tier-2 housing financings/financing sold Cagamas Berhad.
Deduction from EL components:
- Islamic banks are allowed to deduct from the EL components holdings of RM
marketable securities such as Islamic Government and Bank Negara Malaysia
securities; Islamic corporate private debt securities including Cagamas securities; RM
securities issued by Multilateral Development Banks (MDBs) and Multilateral
Financial Institutions (MFIs); and any other securities as specified by the Bank (e.g.
Sukuk BNM Ijarah issued by Bank Negara Malaysia Sukuk Berhad) and ABF
Malaysia Bond Index Fund
- Principal Dealers (PDs) are allowed to deduct from their EL components the daily
holding of specified RENTAS securities in their trading and banking books, and RM
Marketable securities which are not specified RENTAS securities in their trading
book.

Open Market Operations

Open market operations - purchases and sales of financial instruments such as Islamic treasury bills
and government investment issues - are the Bank's principal tool for implementing the monetary
policy. In implementing the monetary policy, the Bank employs open market operations as the
principle source of reserves for the Islamic banking system and currency for the public and as the
principal means of effecting short-run adjustments in reserves. In this context, the Bank financing has
two main roles. Firstly, it acts as a short-run safety valve for the overall banking system by making
additional reserves available when the aggregate supply of reserves provided through open market
4
The example for calculating SRR is given in Appendix A.
 4

operations falls short of demand, thereby preventing an excessive tightening of money market
conditions. Secondly, it enables Islamic depository institutions that are financially sound but have
experienced an unexpected shortage of reserves or funding to make payments while avoiding over-
drafts on their accounts at the Central Bank, at other Islamic banks or when facing shortfalls in
meeting their reserve requirements.
The short-term objective for open market operations is specified by the Bank’s Monetary
Policy Committee (MPC). The Bank's objective for open market operations has varied over the years.
As shown in Table 1, the focus centred on managing excess liquidity in the inter-bank market arising
primarily from large inflows due to international trade and inward portfolio investments. In the
Islamic inter-bank money market, placements under the mudarabah principle are generally undertaken
with the same level of flexibility. The Bank also increased its use of repurchase transactions (repos) as
a means to sterilize excess liquidity. For example, during the year 2005, the value of trading in the
Islamic inter-bank market fell with the decline in mudarabah inter-bank investment transactions. The
decline in mudarabah transactions was also attributed to stable liquidity conditions and the average
rate of returns offered in the mudarabah inter-bank investment transactions.
The Bank can also state its target level for the mudarabah inter-bank funds rate. It can do so
through their meetings which usually include the MPC's assessment of the risks in the attainment of
its long-run goals of price stability and sustainable economic growth.
Table 1 also shows that the Bank can have various financial instruments in their open market
operations.

Table 1: Example of Inter-bank Funds Market and Open Market Operation

2002 2003 2004 2005

RM Billion
Total 280.7 341.4 562.5 356.5

Mudharabah interbank investment* 247.0 283.8 485.7 254.7

Financial instrument 33.7 57.6 76.8 101.8

Islamic accepted bills* 24.8 10.0 10.3 9.4
Negotiable Islamic debt certificate* 0.8 4.2 8.2 8.6
Bank Negara negotiablenotes 2.2 8.9 21.2 36.1
Islamic treasury
bills 0 0 1.2 4.5
Government investment issues 5.9 34.5 35.9 43.2

Sources: Annual Report, Bank Negara Malaysia, various issues

Note: * volume transacted through brokers

Overnight Policy Rate

The overnight policy rate is the mudarabah inter-bank fund rate paid by Islamic banks and other
Islamic depository institutions on financing they receive from the Bank’s financing facility.
Under the facility, financings are extended for a very short term (usually overnight) to Islamic
depository institutions in generally sound financial condition. Islamic depository institutions may also
apply for financing to meet short-term liquidity needs or to resolve severe financial difficulties.
Seasonal financing is extended to Islamic depository institutions that have recurring intra-year
fluctuations in funding needs, such as Islamic banks in agricultural or seasonal resort communities.
 5

For example, the MPC decided to keep its target for the mudarabah inter-bank funds rate at
the level of 3.5 percent due to slower economic growth in the first part of 2007 and to make up for
ongoing adjustments in the housing sector. Nevertheless, the economy seemed likely to expand at a
moderate pace over the coming quarters. Core inflation remained somewhat elevated. Although
inflation pressures seemed likely to moderate over time, as the high level of resource utilization has
the potential to sustain those pressures. This might influence the margin rate for murabahah financing.
From the above discussion, a monetary policy tool is a tool available to the Bank that can be
used to reach its operational target. Today, the Bank uses three such tools, namely reserve
requirements, overnight policy rate, and open market operation.

3. The Concept of an Operational Target of Monetary Policy

Today, there is little debate, at least among central bankers, about what a central bank decision on
monetary policy means: it means to set the level of short term money market interest rate that the
Bank aims at in its day-to-day operations during the period until the next meeting of the Bank’s
decision-making body. Although, the Bank appears to have followed such an approach in practice
most of the time, academic economists favoured during most of the 20th century a rather different
approach to defining the operational target of monetary policy.5 The approach, still today, is very
much debated in monetary economics textbooks. The textbooks contain many references to reserve
position doctrine (RPD) concepts, as for example substantial space is devoted to the money multiplier.
It seems that both have contrasting views. Before, the debate go further, this section will
shortly defines the concept of an operational target of monetary policy, and reviews the possible
specifications of operational targets. The concept of an operational target needs to be distinguished
clearly from two other concepts: the one of a tool of monetary policy, and the one of an intermediate
target. The following definitions of the two (while monetary policy tools have been discussed above)
terms are proposed here.
The operational target of monetary policy is an economic variable, which the Bank wants to
control, and indeed can control, to a very large extent on a day-by-day basis through the use of its
monetary policy tools. It is the variable the level of which the monetary policy decision making
committee of the Bank actually decides upon in each of its meetings. The operational target thus (i)
gives guidance to the implementation officers in the Bank what really to do on a day-by-day basis in
the inter-meeting period, and (ii) serves to communicate the stance of monetary policy to the public.
Today, there seems to be consensus among central banks that the short-term inter-bank interest rate is
the appropriate operational target.
An intermediate target is an economic variable that the Bank can control with a reasonable
time lag and with a relative degree of precision, and which is in a relatively stable or at least
predictable relationship with the final target of monetary policy, of which the intermediate target is a
leading indicator. The typical intermediate target has been a monetary aggregate like M1 or M3, an
exchange rate, or some medium or longer-term interest rate. It is assumed that via its operational
target, the intermediate target can be controlled or at least influenced in a significant way. The
popularity of the intermediate target concept has decreased over the last two decades, and most
previous intermediate targets are considered today more as indicator variables which convey useful
information to the Bank, without that being sufficient to justify a “target” status.
Although these concepts appear reasonably simple and clear, there has been a long tradition
on mixing them up through an imprecise use. Poole (1970), by raising the question “whether to use

5
In the words of Goodhart (1989, p. 293): “The Bank primarily conducts its policy by buying or selling
securities…Academic economists generally regard such operations as adjusting the quantitative volume of the
banks’ reserve base, and hence of the money stock, with rates (prices) in such markets simultaneously
determined by the interplay of demand and supply. Central bank practitioners, almost always, view themselves
as unable to deny setting the level of interest rates, at which such reserve requirements are met, with the
quantity of money then simultaneously determined by the portfolio preferences of private sector banks and non-
banks.”
 6

the interest rate or the money stock as the policy instrument”, had an unfortunate influence in this
respect. Poole (1970, p. 198) defines an “instrument” to be a “policy variable which can be controlled
without error” and considers three possible approaches to its specification (p. 199): “First, there are
those who argue that monetary policy should set the money stock while letting the interest rate
fluctuate as it will. The second major position in the debate is held by those who favor money market
conditions as the monetary policy instrument. The more precise proponents of this general position
would argue that the authorities should push interest rates up in times of boom and down in times of
recession, while the money supply is allowed to fluctuate as it will. The third major position is taken
by the fence sitters who argue that the monetary authorities should use both the money stock and the
interest rate as instruments… the idea seems to be tomaintain some sort of relationship between the
two instruments.”
The merging of the three concepts, clearly distinct in monetary policy practice, makes an
application of Poole (1970) in central banking difficult, but invited academics to work on the same
imprecise lines over decades. The extensive related literature is reviewed e.g. by Walsh (1998). If one
uses the term operational target in the precise sense as defined above, one may categorise the
approaches taken by central banks towards them along the following dimensions. All are somewhat
related to the role of the operational target to communicate the policy stance, either internally within
the Bank or externally.

 Explicit versus implicit operational target. As already mentioned, the Fed defines its federal
funds rate target explicitly, while e.g. the Bank of England and the European Central Bank (or
ECB) stick with an implicit target in the sense that it is revealed with a fair degree of
precision through the rate at which they operate in the market (being an implicit commitment
to achieve similar market rates).4 The Bank of Japan is presently defining an explicit and
quantified quantitative target, namely the amount of total reserves of banks with the Bank of
Japan (see e.g. the press release of 19 March 2001 announcing the policy). The Bank of
Japan’s target implies huge excess reserves, and zero short term market interest rates. It
implies that this quantitative operational target as a second order target, ranking below the
zero percent interest rate target. As the case of the ECB and the Bank of England suggests,
explicitness does not seem to be a necessary condition for an effective communication of the
monetary policy stance to the public.

 Quantified versus non-quantified operational target. A quantified operational target is a target

for which the Bank provides, at least internally, an exact figure after each meeting of its
decision making body. Quantification is a necessary, but not sufficient condition for
explicitness. The Fed’s quantitative operational targets were normally not explicit in the sense
that they were not even quantified. For instance the Bank of England’s implicit short term
interest rate target communicated via the fixed rate of tender operation is a quantified target,
since the level of the tender rate is precisely applied during the inter-MPC meeting period.
Today’s fed funds target rate is both explicit and quantified. In contrast, quantitative reserve
targets were rarely quantified by the Federal Open Market Committee (FOMC) in its
decisions, with the exception maybe of the 1979-82 period (see the FOMC policy records in
the Annual Reports of the Board of Governors). Such a non-quantification of a quantitative
operational target may be considered odd, and leaves uncertain the exact meaning and content
of such operational target. In fact, one could argue that such use of the operational target
concept does not really fulfil the definition one would like to give to such a concept today,
namely to indicate the monetary policy stance for the inter-committee meeting period, both
for the implementation officers in the Bank and to the public. Noting this, Friedman (e.g.
1982) was constantly arguing that the Fed should quantify and make explicit its supposed
quantitative operational targets.

 Public immediate release, or not. Today, most central banks publish immediately after the
meeting of their monetary policy committee the quantification of the level of the operational
 7

target variable. However, this was not always done: for instance the Fed before 1994, and
from 1974-79 did not immediately announce its target specification, and thus the markets
tried to extract it from the (variable rate tender) operations of the Federal Reserve of New
York.

 A unique versus a variety of operational targets. Today, e.g. the Fed has specified one unique
operational target, the federal funds rate. The Fed thus seems to consider the fed funds rate as
a sufficient measure for its monetary policy stance. The opposite approach is described e.g. by
Anderson (1969), according to him there were in the 1960s eight measures of money market
conditions considered by the Fed, namely “the Treasury bill rate, free reserve of all member
banks, the basic reserve deficiency at eight New York money market banks, the basic reserve
deficiency at 38 money market banks outside New York, member banks’ borrowing from the
Federal Reserve, United States government security dealer borrowings, the Federal funds rate,
and the Federal Reserve discount rate.” As mentioned, one could argue that the Bank of Japan
today has two operational targets which have however a clearly defined hierarchical
relationship: short term interest rates should be zero, and within that setting, the operational
target is defined in terms of an (excess) reserves target.

 Choosing between (i) a short-term interest rate, (ii) a quantitative, reserve related concept, or
(iii) a foreign exchange rate. The latter is done by central banks, which peg their own
currency strictly to a foreign one. The focus is on the choice between (i) and (ii). The former
solution was systematically adopted by central banks before 1914, and is standard again
today. The latter was applied at least to some extent in the US, and deemed to be appropriate
in academic circles during the age of RPD, i.e. in the period between around 1920 and around
1990.

With regard to interest rate targets, an important aspect is the maturity of the target rate. Today, the
maturity of the targeted market interest rate seems to be most often the overnight rate, although it is
probably not the overnight rate which is really most relevant in influencing decisions of key economic
agents (consumers, investors, etc.). According to Borio (1997), there were in his sample of 14 central
banks of industrialised countries: 11 with overnight interest rate target, one with a 30 days interest rate
target, and 2 with 30-90 days interest rate targets. In the meantime, the three dissenting ones
(Belgium, Netherlands, UK) all have also embraced the overnight maturity. The striking advantage of
focussing on the overnight maturity is that fully anticipated changes of the operational target in its
case do not lead to anomalies in the yield curve, but such anomalies arise whenever (i) the target is
defined in terms of longer maturities, (ii) changes of the target are anticipated, and (iii) the target is
indeed strictly implemented. Consider for example what needs to happen with the overnight rate
around day T if on day T, a 90 days interest rate target changes in an anticipated way from 4% to 5%
(see Bindseil (2004). The fact that in the past, central banks had a 30 or 90 days target interest rate,
probably meant that they did not implement changes in a strict way from one day to the next, or that
they tried to avoid that changes were well anticipated. Both features would today be deemed to be
sub-optimal, as they conflict with the aims of simplicity and transparency.
By controlling the overnight rate to a fair degree, and by making changes to the overnight rate
target predictable within a well-known macroeconomic strategy of the Bank, medium and longer term
rates, i.e. those judged to be most relevant for monetary policy transmission, will react in a predictable
way to changes in short term rates. It has sometimes been argued that this implies that short run
volatility of the overnight rate is not a problem per se, as it will not necessarily influence medium and
longer-term rates. This is true, and indeed some central banks (e.g. the Bank of England) have
operated with a significant degree of white noise in the overnight rate, without this causing problems
in monetary policy transmission. Also the ECB has accepted some degree of volatility in overnight
rates, although it could have reduced it through more frequent open market operations. Still, one could
argue that, everything else unchanged, white noise in any price does not add value, but creates (maybe
 8

very small) incentives for market players to invest into activities that exploit the variability of prices,
which is, from a social point of view, a waste of resources. In any case, this is less of a monetary
policy, than a market efficiency issue. Only if volatility of overnight rates is very different from white
noise, in the sense that shocks to overnight are rather persistent, it becomes a nuisance for monetary
policy as it will be transmitted to medium and longer term rates (see e.g. Ayuso et al., 2003). This is
certainly the case if the Bank aims at controlling strictly some quantity. RPD generally denied that the
Bank bears responsibility for short term rates, and in its different variants suggested instead the
following operational targets (the list tries to order the different quantitative concepts from broad to
narrow, which is however not obvious in all cases):

 The monetary base, which is the sum of reserves of banks with the Bank and currency.
This tended to be the preferred concept of monetarists, which did not want to go to the
details of day-to-day monetary policy implementation and the implied need to split up
further the monetary base into sub-elements.
 Reserves of banks. As mentioned, this operational target is currently applied by the Bank
of Japan and was also occasionally advocated by academics.
 The total volume of open market operations (Friedman, 1982).
 Non-borrowed reserves, i.e. reserves minus borrowed reserves, applied by the Fed from
 1979 to 1982.
 Excess reserves, i.e. reserves in excess of required reserves (for critical reviews see e.g.
Dow, 2001, or Bindseil et al. 2004).
 Free reserves, i.e. excess reserves minus the reserves the banks have borrowed at a
borrowing facility (in the US case: at the discount window); This concept was applied, at
least in theory, by the Fed during the period 1954 to 1970 (see e.g. Meigs, 1962).
 Borrowed reserves, applied by the Fed from 1982 to 1990.
From the above discussion, there are several findings; the possible categorisation of different
historical and present specifications of operational targets. It is summarised in Table 1.

Table 1: Examples of Operational Targets Specifications

Period Explicit (X) or Quantified Immediately Unique (X) Short term

not (X) or not published (X) or not interest rate
or not (SID) vs. Reserve
concept (RPD)
1960s X x SID
1970s X x x SID
1980s X x x SID
1990s X x x SID
2000s X x x X SID

4. Today’s Model of Steering Short Term Interest Rate

The nature of day-to-day monetary policy implementation needs further clarification and to show how
monetary policy instruments impact on reserve quantities and short term interest rate, this section
presents a brief model which may be called short-term interest rate (STIR) model.

(a) Taylor Rule vs McCallum Rule

While the Bank relies on interest rate targeting in the context of monetary policy, the Bank still needs
a way to choose the target level of interest rate. In deliberating the target level, it needs to incorporate
many factors about the economy. Taylor (1993) has synthesized these factors in the Taylor rules for
interest rate targeting. The Taylor rule states that the current interest rate target should be the sum of
 9

the inflation rate, the equilibrium real interest rate (defined as the interest rate consistent with long-run
full employment), and two additional terms. The first of these terms is the difference between actual
inflation rates and target inflation rates (or known as “inflation gap”); the second is the “output gap” –
the percentage difference of real GDP from its estimated full-employment level. That is, the Taylor
rule states that:

Interest rate target = inflation + Real equilibrium interest rate + (1/2) Inflation gap + (1/2) Output gap

Or the rule can be written as follows:

In this equation, is the target short-term nominal interest rate (e.g. the inter-bank rate), is the rate
of inflation as measured by the GDP deflator, is the desired rate of inflation, is the assumed
equilibrium real interest rate, is the logarithm of real GDP, and is the logarithm of potential
output, as determined by a linear trend.
In calibrating this rule, let say, the equilibrium real interest rate is 2% and the target rate of
inflation is 2%. In practice, implementing the Taylor rule requires estimating the inflation gap and the
output gap.6 For example, if inflation is 4% - so that inflation gap is 4%-2%=2% - and real GDP is
2% greater than full-employment potential GDP, the Taylor rule recommends an interest rate target of
4% inflation + 2% equilibrium real interest rate + (1/2)(2% inflation gap) + (1/2)(2% output gap) =
8%.

However, the McCallum (1993) introduce an alternative monetary policy rule that specifies a
target for the monetary base (MB) which could be used by the Bank. The rule gives a target
for the monetary base in the next quarter (about 13 weeks). The target is:

where

is the natural logarithm of MB at time t (in quarters);

is the average quarterly increase of the velocity of MB over a four year
period from t-16 to t;
is desired rate of inflation, i.e. the desired quarterly increase in the natural
logarithm of the price level;
is the long-run average quarterly increase of the natural logarithm of the real
GDP; and
is the quarterly increase of the natural logarithm of the nominal GDP from t-1
to t.

The explanation of the above formula is as follows. Let, we define the velocity of (base)
money, V, by

6
These gaps reflect the concerns of Bank’s MPC about both inflation and real output fluctuations.
 10

where: M is the money supply (in our case, the monetary base, MB); and X is the aggregate
money traded for goods or services (in our case, the nominal GDP for the quarter in
question). Then, let we define the price level, P, (in our case, the GDP deflator divided by
100) by

where Q is the quantity of goods or services exchanged (in our case, the real GDP during the
quarter). Together, these definitions yield the so-called equation of exchange

Now, define m, v, x, p, and q as the natural logarithms of M, V, X, P, and Q. Then the

equation becomes

These quantities are functions of time, t, which we will take to be an integer which counts the
quarters of years. So mt means the (average) value of m during the t quarter. The forward
difference operator, is defined by

If we apply the forward difference operator, we get

and so

The velocity of money changes due to changes in technology (e.g. ATM, and payment
mechanism) and regulation (e.g. financing loss provision and required reserve requirement).
McCallum assumes that these changes tend to occur at the same rate over a period of a few
years. He averages over four years to get a forecast of the average growth rate of velocity
over the foreseeable future. Thus one approximates

The velocity term is not intended to reflect current conditions in the business cycle. Then, we
assume that when the rate of inflation is held near its desired value, for an extended
 11

period, then the growth rate of real GDP will be near to its long-run average, And thus
that the growth rate of nominal GDP will be close to their sum

However, it is not obvious what that desired value of inflation should be. McCallum takes the
long-run average rate of growth of real GDP to be 3 percent per year which amounts to

on a quarterly basis. He expects the Bank to choose an inflation target of 2 percent per year
which amounts to

on a quarterly basis (although he would personally prefer a lower inflation target). So the
target for the monetary base should be given by a rule of the form

where is a correction term which can only depend on information available at time t. The
correction term is intended to compensate for current cyclical conditions. It should be
positive when recent growth of output and the price level has been slow. If one takes the
correction to be

then the result is McCallum's rule. A large resulting increase in MB tends to generate or support a
rapid rate of increase in broader monetary aggregates and thereby stimulate aggregate demand for
goods and services. The figures used for the monetary base (MB) should be the adjusted base. The
adjustments serve to take account of changes in legal reserve requirements that alter the quantity of
medium-of-exchange money (such as M1) that can be supported by a given quantity of the base.

(b) Benchmark for Financial Transactions

Inflation is usually measured as the change in prices for consumer goods, called the Consumer price
index (CPI). Inflation targeting assumes that this figure accurately represents growth of money supply
(due to an increase in financing)7, but this is not always the case. The most serious exception occurs
when factors external to a national economy are the cause of the price increases. The oil price
increases since 2003 and the 2007-2008 world food price crises combined to cause sharp increases in
the price of food and consumer goods, which in turn resulted in a sharp increase in CPI. This is
especially true in the very emerging markets that often follow the new policy of inflation targeting,
because they are often dependent on imported oil or food.
Currently, interest rates are used as a benchmark for financial transaction in Islamic banking
system. Taylor rule might need to be re-evaluated because the final impact is on the volume of
financing that comprise the cost of acquiring assets and profit margin that has an impact on the price

7
Through the multiplier effect, an increase in financing would increase the money supply.
 12

level. Hence, if the Bank changes the benchmark, the amount of financing for particular years would
also change. In addition, the amount of financing (overtime) could also capture the price level.
Therefore, the inflation rate tend to be positively related, the likely moves of the Bank to raise or
lower interest rates become more transparent under the policy of inflation targeting. For example:
 if inflation appears to be above the target, the Bank is likely to reduce interest rates (in
conventional way, the Bank is likely to increase interest rate, because inflation and
interest rates is inversely related). This usually (but not always) has the effect over time
of cooling the economy and bringing down inflation.
 if inflation appears to be below the target, the Bank is likely to increase interest rates.
This usually (again, not always) has the effect over time of accelerating the economy and
raising inflation.
Under the policy, investors know what the Bank considers the target inflation rate to be and therefore
may more easily factor in likely interest rate changes in their financing choices. This is viewed by
inflation users as leading to increased economic stability.
Therefore, since the benchmark is exogenously determined by the Bank, hence the only
option available for Islamic banks is through the changes in percentage margin in order to curb the
inflation rate. The lower margin might be translated into a lower the inflation rate. Therefore,
benchmark and inflation rate is positively related.

(c) The Lesson from Zero Interest Rate Policy

The zero interest rate policy (ZIRP) is a concept in macroeconomics where economies exhibit slow
growth with a very low interest rate. For example in February 2009, Japan’s benchmark interest rate
was 0.3 percent and recently headed to zero. The U.S. federal funds rate was 1 percent and headed
lower, too. The U.K.’s rate is 2 percent, Canada’s is 2.25 percent and the euro zone’s is 2.5 percent.
As the fallout from the global crisis worsens, these and many other benchmark rates will edge toward
zero.8
Under ZIRP, the Bank maintains a 0% nominal interest rate. The ZIRP is an important
milestone in monetary policy because the Bank is no longer able to reduce nominal interest rates.
Many economists believe that monetary policy becomes ineffective under ZIRP, because the Bank
has no more tools left to reinvigorate the economy. Some economists argue that, when monetary
policy hit the lower bound of the ZIRP, government's must use fiscal policy. The fiscal multiplier of
government spending is expected to be larger when nominal interest rates are zero than they would be
when nominal interest rates are above zero. Moreover, the multiplier has been estimated to be above
one, meaning government spending effectively boosts output.

5. RPD According to Economists

The current debate on reserve position doctrine could be discussed according to three different views,
i.e., Keynesian, Monetarist and Islamic Economists.

a. Keynesian View

From the early 1930s until the early 1950s, monetary policy had, in the US and many other countries,
a break in the sense that short term interest rates were anyway at or close to zero, and that the main
danger was deflation, not inflation. RPD emerged in the US with consolidated dominance after this
break. It is plausible that one reason for this was the enthusiastic support to RPD by Keynes, mainly
in the second volume of his Treaties on Money of 1930. This support seems surprising today, the

8
William Pesek (2009) Fed, BOJ Signal that we Are All Islamic Bankers Now, refer to
http://www.musliminvestor.net/banking/bank-of-japan-gives-away-money-interest-free/
 13

more as Keynes’ argumentation appears to have obvious weaknesses. Maybe two psychological
factors may help to understand what went on in Keynes’ mind when he provided such transatlantic
help to RPD. First, Keynes of course liked modern, affirmative approaches, and RPD, having emerged
in the 1920s from scratch, was exactly such a theory. Secondly, RPD was, as will be described below,
systematically ignored by the Bank of England, and Keynes had more and more during the 1920s
become a general arch-critic of the “orthodoxy” of the Bank of England. Thus, praising RPD was also
an additional way for Keynes to attack the Bank of England’s supposed refusal to accept modern
thinking.
Nevertheless, Keynes’ (1930, p. 226) defense of RPD is very interesting, because it more
explicitly addresses a number of related key issues than any other author of his time, and thus guides
us today most easily to the weaknesses of RPD:

“The first and direct effect of an increase in the Bank of England’s investments is to cause an
increase in the reserves of the joint stock banks and a corresponding increase in their loans
and advances on the basis of this. This may react on market rates of discount and bring the
latter a little lower than they would otherwise have been. But it will often, though not always,
be possible for the joint stock banks to increase their loans and advances without a material
weakening in the rates of interest charged”.

Today, and that should have been valid also in the 1920s, one would argue that the money
market rates obviously always react faster than the loan and investment policy of banks, i.e. it is
precarious to assume that “the first and direct effect” of excess reserves are additional loans. As is
well known to anybody who had been in direct contacts to money markets at least since Bagehot
(1873), small excesses or deficits in the money market are sufficient to push interest rates to zero or to
very high levels, respectively (or to the levels of central bank standing facilities). In addition, whoever
has worked in the credit department of a bank, will confirm that the decision to grant a loan is never
done on the basis of the bank’s current level of excess reserves. Excess reserves can be traded in the
money market, and what matters is their opportunity cost. Seeing perhaps the flaw in his argument,
Keynes (1930, p. 227) takes recourse to more sophisticated reasoning:

“I fancy that a considerable part of the value of open market operations delicately handled by
the Bank may lie in its tacit influence on the member banks to move in step in the desired
direction. For example, at any given moment a particular bank may find itself with a small
surplus reserve on the basis of which it would in the ordinary course purchase some
additional assets, which purchase would have the effect of slightly improving the reserve
positions of the other central banks, and so on. If at this moment the Bank snips off the small
surplus by selling some asset in the open market, the member bank will not obstinately persist
in its proposed additional purchase by recalling funds from the money market for the
purpose; it will just not make the purchase… In this way a progressive series of small
deflationary open-market sales by the Bank can induce the banks progressively to diminish
little by little the scale of their operations… In this way, much can be achieved without
changing the bank rate.”

But again, the assumptions taken appear too arbitrary and to lack micro-foundation. What one
finds today least convincing is that the whole argument seems to rely on a lack of willingness of the
banks to arbitrage, which is not even well explained. In fact, Keynes (1930) himself recognizes that
his enthusiasm for open market operations goes beyond the one of many central bankers of the 1920s.
Finally, it is worth noting that Keynes also promoted the idea to actively use changes of reserve
requirements for the control of excess reserves of banks, and thus, via the money multiplier, of credit
and monetary expansion. Keynes (1930) introduces the case by an example from the UK, in which no
reserve requirements were imposed at that time:9
9
Currently, in Malaysia, non-banking institutions are also exempted from allocating reserve at the Bank
 14

“The Midland Bank had… maintained for some years past a reserve proportion a good deal
higher that those of its competitors... beginning in the latter part of 1926, a gradual
downward movement became apparent in the Midland Bank’s proportion from about 14.5%
in 1926 to about 11.5% in 1929… this… in fact enabled the banks as a whole to increase their
deposits (and their advances) by about GBP 100 million without any new increase in their
aggregate reserves… Now, as it happened, this relaxation of credit was in the particular
circumstances greatly in the public interest… Nevertheless, such an expansion of the
resources of the member banks should not, in any sound modern system, depend on the action
of an individual member bank… For we ought to be able to assume that the Bank will be at
least as intelligent as a member bank and more to be relied on to act in the general interest. I
conclude therefore, that the American system of regulating by law the amount of the member
bank reserves is preferable to the English system of depending on an ill-defined and
somewhat precarious convention”

Keynes (1930) then proposes a concrete specification of a reserve requirement system, to

conclude enthusiastically on its power: “These regulations would greatly strengthen the power of
control in the hands of the Bank of England – placing, indeed, in its hands an almost complete control
over the total volume of bank money – without in any way hampering the legitimate operations of the
joint stock banks.” This argumentation was taken up by central banks, and for instance the Board of
Governors of Bank of England to list the three main instruments of monetary policy implementation
as follows: “Discount operations, Open market operations, Changes in reserve requirements” , i.e.
reserve requirements were a relevant tool especially in so far as they could be changed. Indeed, both
the Federal Reserve and the Deutsche Bundesbank frequently changed reserve ratios from the 1950s
to the 1970s, giving evidence that RPD also determined their understanding of this instrument of
monetary policy.
As one example of the countless changes of reserve requirements in the US during that
period, and how directly they were apparently motivated by RPD, consider the following Fed policy
action of August 1960 (from Annual report, Digest of principal federal reserve policy actions; similar
changes were implemented again in November of the same year):

“Authorized member banks to count about $500 million of their vault cash as required
reserves, effective for country banks August 25 and for central reserve and reserve city banks
September 1. Reduced reserve requirements against net demand deposits at central reserve
city banks from 18 to 17 ½ per cent, effective September 1, thereby releasing about $125
million of reserves”

b. Monetarist View

Generally, monetarists, who liked quantities, but tended to dislike the idea of central bank control of
(short term) interest rates, broadly supported RPD, although they were often not so keen on being
bothered with a need to split up their most cherished concept for monetary policy implementation, the
monetary base, into petty-minded technical concepts like excess reserves, free reserves, borrowed
reserves, etc. It seems likely that popular monetarists like especially Friedman played an important
role to prevent RPD from being silently buried already in the late 1960s.
The maybe most detailed discussion of monetarist theory applied to monetary policy
implementation is Friedman (1960). Friedman (1960) argues that open market operations alone are a
sufficient tool for monetary policy implementation, and that standing facilities (e.g. the US discount
facility) and changing of reserve requirements could thus be abolished:

“The elimination of discounting and of variable reserve requirements would leave open
market operations as the instrument of monetary policy proper. This is by all odds the most
efficient instrument and has few of the defects of the others… The amount of purchases and
 15

sales can be at the option of the Federal Reserve System and hence the amount of high-
powered money to be created thereby determined precisely. Of course, the ultimate effect of
the purchases or sales on the final stock of money involves several additional links… But the
difficulty of predicting these links would be much less… The suggested reforms would
therefore render the connection between Federal Reserve action and the changes in the
money supply more direct and more predictable and eliminate extraneous influences on
Reserve policy.”

What may be most striking in Friedman’s (1960) analysis is his silence on the role of short
term interest rates and in particular about the fact that his proposals would imply a high volatility at
least of short and medium term rates. Similarly, Friedman and Schwartz (1963) in their critique of the
Federal Reserve policy in the 1930s, show little curiosity for interest rates, but argue again and again
in a strict multiplier framework. They follow the historical development of the monetary base and
monetary aggregates to argue within the multiplier model that open market operations could have
increased the monetary base and hence the money stock, preventing or at least attenuating the crisis of
the 1930s (p. 393):

“If the deposit ratios had behaved as in fact they did, the change from a decline in high
powered money of 2 ½ per cent to a rise of 6 ½ per cent… would have changed the monetary
situation drastically, so drastically that such an operation was almost surely decidedly larger
than was required to convert the decline in the stock of money into an appreciable rise.”

The probably most extreme statements of monetarist views on monetary policy implementation can be
found in Friedman (1982). Friedman (1982, p. 101) summarizes what he regarded as the predominant
opinion on monetary policy implementation at that time, and what could not be more different from
today’s homogenous view of central bankers (or the pre-1914 view, etc.):

“Experience has demonstrated that it is simply not feasible for the monetary authority to use
interest rates as either a target or as an effective instrument… Hence, there is now wide
agreement that the appropriate short-run tactics are to express a target in terms of monetary
aggregates, and to use control of the base, or components of the base, as an instrument to
achieve the target”.

He then elaborates a rather concrete proposal regarding open market operations:

“Set a target path for several years ahead for a single aggregate – for example M2 or the
base. … Estimate the change over an extended period, say three or six months, in the Fed’s
holdings of securities that would be necessary to approximate the target path over that
period. Divide that estimate by 13 or 26. Let the Fed purchase precisely that amount every
week in addition to the amount needed to replace maturing securities. Eliminate all
repurchase agreements and similar short-term transactions.”

This proposal is in fact neither a reserve, nor a monetary base target, but an “open market
operations quantity” target, and thus an additional variant of an RPD inspired operational target of
monetary policy. It is again too difficult to imagine how this proposal would work in practice, and
why it should make sense if we accept the realities of the money market as first described by Bagehot.
Despite the trend of the last 20 years back towards SID, monetarists have insisted on their
views on monetary policy implementation until very recently. In a Wall Street Journal article of 20
August 2003, Friedman again advocates his approach as described for instance in 1960 and 1982.
Meltzer (2003) also reviews the Federal Reserve’s early history largely from a RPD perspective, and
argues, without a reference to interest rates, that (pp. 62-63) a “complete theory of the monetary
system” requires studying all aspects of the monetary base (and its components).
Although today’s central bankers are likely to reject the monetarist approach to the choice of
the operational target of monetary policy as just one more, and even particularly reality-distant,
 16

variant of RPD, Friedman needs to be praised for having always insisted on the point that a target that
is not quantified (i.e. for which no concrete figure is given), cannot be a serious target, and leaves in
the dark what the Bank is actually aiming at. This includes the operational target, which the Fed did
not want to specify since 1920. By insisting that the Fed should concretely quantify its supposed
quantitative targets, he eventually contributed to push it into the 1979-82 episode, which then revealed
so easily the non-practicability of RPD. It is the more astonishing that Friedman has remained an un-
compromised supporter of RPD until today.
Once the Fed had given up non-borrowed reserves targeting procedures in 1982, pressure on
the Bank of England to adopt RPD faded away (Goodhart, 1989 and 2004), and the Bank of England
thus eventually had a very narrow escape from applying RPD at any moment during the 20th century.

(c) Islamic Economists

As mentioned above, fractional-reserve banking is the banking practice in which banks keep only a
fraction of their deposits in reserves (as cash and other highly liquid assets) and lend out the
remainder, while maintaining the simultaneous obligation to redeem all these deposits upon demand.
This practice is universal in modern banking, and is to be contrasted with full-reserves banking which
died out over two centuries ago.
By its nature, the practice of fractional reserve banking expands money supply (cash and
demand deposits) beyond what it would otherwise be. Because of the prevalence of fractional reserve
banking, the broad money supply of most countries is a multiple larger than the amount of base
money created by the Bank. That multiple (called the money multiplier) is determined by the reserve
requirement or other financial ratio requirements imposed by financial regulators, and by the excess
reserves kept by banks.
Thus, fractional reserve banking is a consequence of bank lending, as a bank necessarily has
cash reserves that are only a fraction of deposits when it lends some of those deposits out. The
fractional reserve system allows banks to act as financial intermediaries - facilitating the movement of
funds from savers to investors in a society. Both Keynesian and monetarists view the fractional
reserve banking as a form of financial intermediation. This intermediation is essential in the money
(or credit) creation process. The injections of these variables might changes the prices and quantities
in the economy.
Imam Ghazali (1058-1111 AD), Choudhury (2005) and Ahamed Kameel (2002) to whom
Islamic economists owe a great debt for their contributions to monetary theory. They have
consistently stressed the importance of money as a medium of exchange and the importance of bank
in facilitating those exchanges. Their contribution could also be seen in treating money as capital. Due
to this, the latter two authors disagree on the imposition of fractional reserve on Islamic banks.

6. The Lessons from RPD

Although RPD has been established since day one of modern banking system, but the doctrine is not
without critics. In this section, several lessons could be highlighted.

(a) Liquidity Problem

The advantage to fractional-reserve banking is that it allows banks to generate income on the funds
deposited. Once a bank borrows from customers to make a loan to another bank customer, it gets to
charge interest on the loan, receiving the interest. If customers have money in an account which
generates interest, customers get a cut of the interest charged on loans, but the bank still receives a
significant portion of it. Fractional-reserve banking is big money in a very literal way, which is why
so many banks like this system.
 17

The disadvantage of fractional-reserve banking is that it puts banks in an awkward position

when it comes to liquidity. While banks are not required to retain their deposits on hand, they have to
be able to redeem deposits upon request, as for example when a customer goes in to close a checking
account. If a group of depositors all ask for their money bank at once, in a situation known as a bank,
the bank may not have enough funds on hand, which could be a serious problem.
Liquidity problems can be compounded when a bank makes poor lending decisions, and
borrowers default on loans. When a customer defaults, the bank loses the borrowed money, along
with the income from interest, and it must scramble to make up the shortfall. Too many bad loans can
cripple a bank, causing it to become insolvent.
To address depositor concerns, some countries have government agencies which insure
deposits up to a certain amount, and these agencies may also perform regular audits on the banks
which they back to ensure that they are not taken by surprise when a bank becomes insolvent. In
addition, to mitigate these problems, the Bank (or other government agencies like PDIM) generally
regulate and monitor banks, act as lender of last resort to banks.

(b) Financial System Design

Initial discussion, as reported above, shows that there are two channels through which the monetary
policy changes affect economic activity and inflation. These channels are interest rate channel and
money channel. However, as stated in Gordon (2002), one reason for the change in the monetary
transmission mechanism could be due to the significant structural changes in the financial system.
Since, the monetary transmission mechanism depends on banks and financial markets to channel
monetary policy actions, changes in the structure of the financial system could alter the monetary
transmission mechanism. In other words, the structure of the financial system might change the
financial system design.
As a result, the financial system design processes prompted a reassessment of the
transmission mechanism through which monetary policy affects the aggregate demand and ultimately
the final variables of prices and output. If the financial markets become dominant, then mostly the
capital market plays an important role in channelling funds to the economy. The new financial
landscape and financial reforms undertaken in capital market might open up new avenues and
increased opportunities for financial market development. However, in this new environment with
closer financial integration and strong capital flows, the effectiveness of monetary policy has often
been questioned. Financial reform and development had important implications for both the
transmission mechanism, and the operating procedure of monetary policy. It has actually altered the
channels of monetary policy mainly affecting the relationship between monetary aggregates,
financing aggregates and return on investment and profits. These changes posed a major challenge in
the formulation and implementation of monetary policy.
In view of the changing financial environment, the monetary policy should adhere to a
suitable policy framework so that it can remain as an effective policy in promoting economic growth
and maintaining price stability. Furthermore, there exist different views of the exact channels of the
monetary transmission mechanism. An understanding of the transmission channels is essential to the
design and implementation of monetary policy. A direct empirical investigation of the effect of
Islamic banking system on real activities is exactly what we investigate in this research. We strongly
feel that the financial intermediaries (we emphasize on banking sector) play an important role in
monetary transmission to uphold the conduct of monetary policy in dual banking system in Malaysia.

7. Suggestions

In this section, we are suggesting that on the tools for the working of monetary policy.

(a) Profit-loss Sharing Ratio

 18

The higher inflation rate might be reduced by reducing interest rate. However, the reduction in interest
rate is not effective if it reach the zero level. The effective way is to introduce the fiscal policy. But, it
might increase the level of budget deficits. Therefore, both policies might produce the unhealthy and
unsustainably economy. The prescription is to move to profit-sharing ratio policy.
In profit-loss sharing mechanism, the profit, that can be generated, comes from the revenue.
This revenue is derived from the quantity sold and the price level. Since, price level is determined by
supply and demand, then whatever the price level is, it will generate the profit for entrepreneur (after
cost deduction), which later, will be shared between capital provider and entrepreneur. Therefore, the
percentage shares of profit-sharing mode of financing might off-set the increase in the price level
which is due to the changes in percentage margin.
In analysing the effect of profit loss sharing on the price level, this paper will adopt the
following equation:

Since mt+1 might include new savings (st+1) and profit received (dt+1), then the above equation can be
re-written as:

st+1 +dt+1 = ∆ x t – ∆vt

From the above equation, if v is assumed to be stable, then the increase in the natural logarithm of
nominal GDP might increase both variables on the left side. In other words, if the Bank chooses the
inflation and real GDP targets, then the amount of profits should be set by the rule. The intention of
the rule is to preserve the wealth (i.e., both savings and profits).

(b) Full Reserve

The alternative to fractional-reserve banking is full-reserve banking, in which a bank must be able to
hold all of its deposits on hand.10 Full-reserve banking is a theoretically conceivable banking practice
in which all deposits and banknotes in a financial system would be backed up by assets with a store of
value. This implies the existence of a government body (such as a central bank) that would convert
currency to a more stable type of asset if requested to do so. It also implies that the resources available
to the Bank (and banks) would be sufficient to convert all currency if so required.
With this alternative, all banks operating in such a system would be 100%, making the deposit
multiplier equal to zero. In such a system, banks would have no obvious incentive to offer savings or
checking accounts, unless users paid a fee for those services.
A system in which all currency is backed by another asset and banks are required to maintain
a 100% cash reserve ratio has never been implemented in any actual economy. The closest system is
that of a currency board, in which banks are not required to maintain a 100% cash reserve, but all of
the money in circulation, is backed by another asset held by the Bank. This system is in use in Hong
Kong where the Hong Kong dollars is backed by United States dollars.
In theory, as suggested by many scholars such as Kameel (2002) and Masudul (2005) Islamic
banking should be synonymous with full-reserve banking, with targeting a 100% reserve ratio. The
main reasons is that the counter-inflationary effect of Islamic loans, it could be sensible at times to
remove the restraint of 100% reserve requirement and credit issued by the Bank for productive
investment
The conventional banks and banking system today endlessly create money. They are the real
source of inflation and it happens because of the practice of fractional reserve banking which allows a
bank to lend many times its reserves. But, because a bank only creates money for the principal of a

10
There is no such fractional reserves that has been imposed non-banking institutions
 19

loan and not for the interest, the banking system as a whole must continually increase the overall
amount of debt if the economy is not to collapse. The fractional reserve system is why house prices,
for example, have been rapidly rising right the way around the world and some form of bust is
inevitable.
So, with an Islamic money supply for productive capacity, it will also be policy, over time, to
increasingly restrain the banking system from creating new money. This would be done by gradually
increasing (eventually to 100%) the reserves that a bank must deposit with the Bank. Thus, as interest-
bearing money from the banks decreases, interest-free loans (from the Bank, but administered by the
banking system) will increase thereby fulfilling the need of an economy for credit to be made
available for productive investment.
Thus, banks would become essentially depository and investing institutions who could only
lend depositors’ money with the agreement of depositors (although they would have other functions
e.g., administering interest-free loans for productive capacity). The banking system will then be doing
what the public believes banks do and what the banking system allows the public to believe, namely,
lending its own and its depositors’ money.
Increasingly, there will be less need for control of the economy via interest rates. The overall
volume of money in the economy context will be the key factor and the Bank could change the
percentage of reserves a bank must deposit. Islamic endogenous loans start with the Bank and
eventually get repaid to the Bank. The use of the loans would be confined to public and environmental
capital projects, small and start-up businesses and large corporations as long as wide capital
ownership is furthered. Because of no interest the general result would result in a halving at least of
the cost of new productive capacity and a huge reduction in debt.
However, the typical structure of uses and sources of funds in Islamic bank shows that
Islamic banks can influence the economy via three important monetary variables: financing (i.e.,
financing for capital and consumption; and financing for government budget); deposits (i.e., be part of
money supply) and investment.11

8. Conclusions

The aim of this paper is to identify the tools in controlling the monetary variables in Islamic banking
system. The results from this paper show that: first, in formulating the monetary policy, the Bank has
the choice to use three tools: reserve requirements, overnight policy rate, and open market operation.
Second, theoretically, both short-term interest rate model and reserve position doctrine are used as
target variables. Third, this paper suggests the profit sharing ratio and full reserve as tools for the
working of monetary policy in Islamic banking system.

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11
The typical balance sheet of Islamic bank is shown in Appendix B.
 20

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Appendix A: The Calculation of SRR

The eligible liabilities for the month of October 2007 are given as follows:

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
10.0

16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31
10.0

The eligible liabilities of Base Period A and Base Period B are given, respectively, as follows:
 21

EL Base Period A = (202+197+….+200+200) ÷ 15 = RM 200 million

EL Base Period B = (205+214+…..+241+244+249) ÷ 16 = RM 225 million

Calculation of the statutory reserve requirement is given below:

SRR compliance period: 1 to 15 November 2007

Corresponding EL base:1 to 15 October 2007
EL Base Period A: RM 200m
Variation band: 3.2% to 4.8%.

Therefore, the minimum daily balance to be maintained in the Statutory Reserve Account from 1 to 15
November 2007 = RM6.4m (3.2% of EL Base Period A)

Appendix B: Balance Sheet Compositions of Islamic Bank

Table below shows the differences between the balance sheet of Islamic banks and conventional
Islamic banks. One of the major differences between an Islamic bank and a conventional Islamic bank
is that; the former mobilizes funds on a profit and loss sharing basis while there is no similar concept
on the sources (liabilities) side in conventional Islamic banks. On the uses (assets) side, the portfolio
of Islamic banks is composed of various finance contracts (or modes of financing) many of which are
based on profit and loss sharing principles such as musharakah and mudarabah. Thus, unlike the
situation in conventional banking, the customer-banker relationship in Islamic banking is not a mere
debtor/creditor relationship. On the liability (sources) side for conventional banks, deposit funds
mobilized on sight and time deposit basis constitute an ultimate liability, as principles of these funds
as well as their fixed (pre-determined) interest rates are contractually guaranteed.
Balance sheet information is reported quarterly to stockholders, the public and to regulatory
agencies in a Report of Condition and Income. This report is sometimes referred to as the Call Report,
harkening back to days when the Bank’s chartering authority would make a surprise "Call" for its
position statement.
The review of the daily analysis of an Islamic bank's condition may be too burdensome for the
board of many Islamic banks. Yet, the quarterly review analysis based on the Call Report may be too
infrequent and delay the board's ability to respond to urgent matters. Unless an Islamic bank is
experiencing severe operating problems, a monthly analysis may be a good compromise. Most boards
that meet monthly conduct a monthly review.

Stylized balance sheet of Islamic banks Balance sheet of conventional banks

Assets Assets
Cash and cash equivalents Cash and cash equivalents
Investment in securities Investment in securities
Sales receivables Loan and advances
Investment in leased assets Statutory deposits
Investment in real estates Investment in subsidiaries
Equity financing Fixed assets
Equity investment in capital ventures Other assets
Inventories
Investment in subsidiaries
Fixed assets
Other assets
Liabilities Liabilities
Current account Deposits
 22

Other liabilities Other liabilities

Equity of Profit Sharing Investment
Accounts (PSIA)
Profit sharing investment accounts Determination of return to depositors based on
Profit equalization reserve actual portfolio yield
Investment risk reserve
Owners’ Equity Owners’ Equity

Source: Abdul Ghafar Ismail (2010) Money, Islamic Banks and the Real Economy: Singapore:
Cengage Learning.