Islamic Economics

INTEREST-FREE ECONOMICS AND THE ISLAMIC MACROECONOMIC SYSTEM
Author(s): Zaidi Sattar

Source: Pakistan Economic and Social Review, Vol. 27, No. 2 (Winter 1989), pp. 109-138
Published by: Department of Economics, University of the Punjab
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Pakistan Economic and Social Review
Vol XXVII No.2 (Winter1989)pp 109-38
INTEREST-FREE ECONOMICS AND

THE ISLAMICMACROECONOMICSYSTEM
Zaidi Sattar*
Abstract
The elimination of interest rates on bank loans, deposits and debt,

in general, in the Islamic economy introduces unique behavioral
relations within the economic
Islamicsystem. The present paper
a
provides the framework for macroeconomic system within which these
relations and their impacts on the aggregate economy are analysed.
The profit rate emerges as the key variable driving the system.
This is demonstrated through an analytical framework that is a suitable
extension of the conventional Hicks-Keynes model. In the absence of any
role for the interest rate variable, the following essential features of the
model are highlighted:(a) the relation between the profit rate and the
profit-sharing ratio; (b) investment demand as a function of the profit
rate; (c) the transmission mechanism between the money and goods
markets; (d) simultaneous and convergent equilibria in the two markets;
(e) steady state analysis and dynamic adjustments to changes in the
policy environment Using standard neo-Keynesian macroeconomic tools
suitably modified to conform to the workings of an interest-free

economic system, the building blocks of a complete macroeconomic
model are laid doom, and the stable properties of its solutions examined
for noting the impacts of changes in the policy environment.
Department of Economics and Business, The Catholic University of

America, Washington, D.C., USA.

110 Za di Saltar
This paper demonstratesthatmost of the desirablepropertiesas

evidenced in the Hicks-Keynes model are retained in this model devoid
of interest rates. Furthermore, a distinctive outcome of the policy
experiment within the model reveals an intricate interdependence

between monetary and fiscal policy instruments for achieving the
desiredgoals ofstabilityor economicgrowth.Though onlya preliminary
exercise, this paper could potentially serve as the platform for further
theoretical explorations into the workings of the Islamic macroeconomic
system.
"0 ye who believe! Fear God, and give up what remains of your
demand for usury, ifye are indeed believers". ~ Al Quran (II: 278)
Ali (1977)
1 Introduction
Interest-based system of transaction and exchange has been the

corner-stone of the free market system from time immemorial. So much
so that the interest rate has served as the criterion for evaluating
individual or social time preference. The prosperity or stagnation of the
economies of today is inseparably linked to the movements of domestic
or global interest rates. In the capitalistic world, it is difficult to find
another single economic variable that is as critical to the state of the
economy as the rate of interest.
It should be no surprise then that, following the injunctions of the

Holy Quran, breaking away from a system so deeply rooted in modern
human society, should present the economies so embarked, with
challenges that are both complex and unfamiliar. Yet the first bold steps
have already been taken.
After several years of careful examination, in 1983, Iran

completely transformed its banking system prohibiting transactions
Riba (interest).
involving Althoughbegun earlier (1978),Pakistan opted
for a gradual transformation from an interest-based to an interest-free
system. Other Muslim countries like Egypt, Saudi Arabia, the Sudan,
United Arab Emirates, to name a few, have been experimenting with
interest-free banking systems alongside conventional banking since the
sixties and early seventies. It is noteworthy that the large-scale
emergence of interest-free banks in the above countries as well as some

Interest Free Economics & Islamic Macroeconomic system 111
non-Muslim countries of Europe

(Switzerland, Luxembourg) coincided
with the oil boom of the mid-seventies which accounted for the economic
prosperity of many an oil-rich Muslim nation. Today some 40 Muslim
countries have interest-free banks.
It would be follyto presume that the transformationof the

banking or financial system meant the establishment of purely Islamic
economies guided only by the dictates of the Quran and Sunnah, and
where all laws conform to the principles laid down by the Sharia'h.
Thus, to be candid, the rank and file ofMuslim nations around the globe
are admittedly only partially Islamic economies. Economic analysis of the
workings of an Islamic economy must therefore be based on rather strict

and limiting assumptions the behaviour of Islamic governments
about
and its citizens (assumed to be adhering to the tenets of Islam in its
entirety) somewhat similar to the analysis of perfect competition within

the framework of a market economy. Such is the intent of the present
paper whose objectives are limited to the depiction of macroeconomic
equilibrium, its stability, and the adjustment paths traced in response to
policy changes. The standard neoclassical tools as well as the recent
approaches used in macroeconomic analysis will be adopted so as to

enable a comparison of the contrasting outcomes.
2. Rationale for an Interest-free System
"Allah has blighteth Riba and made Sadaqat fruitful".

Al Quran (11:276)
Pickthall (1953)
The Holy Quran is categorical in its denunciation of the practice of

usuiy, understandably due to the exploitative nature of the burden of
payment imposed on the debt. The pertinent issue, however, iswhether

all forms of interest as witnessed in present day economies should be
treated at par with the practice of usuiy. Although not central to this
paper, an attempt will be made here to summarize the various
arguments pertaining to the notion that interest is Riba and thereby

subjectto theQuranic prohibition.
Mahmoud Abu-Saud (1986) has made an exhaustive examination

of this issue. Drawing on the Quran and some authoritative Hadith on
the subject of Riba. Abu Saud concludes that what is definitely

112 Zaidi Sattar
prohibited in Islam is traditionally referred to as "Riba al-Fadhl", known

alternatively as usury of excess or usury of deferment. He cites the jurist
Ibn-QayyimalJawziyah: "He (theProphet-PBUH) forbadethemto incur
the excess Riba (Riba al-Fadhl) he was
afraid they would delve
because
into the deferred Riba". Again citing from the interpretation fromHadith
narrated by Usama and Ibn-Abbas: "There is no Riba but in deferment".
Upon close examination of the Quranic verses prohibiting Riba

and subsequent statementsof theProphet (PBUH), it is apparent that
what is prohibitedin Islam is the deferredexcess payment involvedin
financial borrowing.Although this is none other than the rate of
interest, Abu-Saud takes pains to explain circumstances in the modern
world, particularly in the industrial West, where ordinary Muslims in
their day-to-day transactions with commercial banks need not suffer the
guilt ofHARAM by association. Specifically, he finds such transactions
as interest-based demand deposits1, real estate mortgages2, and
commercial bills of discount, not Riba, while financial instruments such
as corporate bonds or time deposits veiy much so.
What seems clear from his analysis

to be is that some
conventional banking transactions involve Riba while others do not, and,
therefore, Muslims living across the Western world have the option of
selectively engaging in financial transactions, avoiding those that are
prohibited. Such an analysis, in my view, ignores a fundamental fact of
conventional financial institutions in the modern world. Their methods
of mobilising financial resources and engaging in the enterprise of
banking for profit unequivocally involves, at the source, deferred excess
payment or Riba. Given that basic fact, innumerable auxiliary
transactions do arise which need not be prohibited. Thus the idea of an
Islamic financial system involves total not partial conversion of the entire
financial institution of an economy nay of the entire international
economy of the Muslim world, at the veiy least, on fundamental Islamic
principles regarding financial transactions (i.e. abolition of all forms of
usury or Riba). The Prophets (PBUH) last sermon addressing the
matter of usury should settle the whole issue: "....Allah has forbidden
you to take usury (interest), therefore, all interest obligations shall
henceforth be waived". {Prophet's (PBUH) last sermon at Uranah Valley
ofMount Arafat}.

3. Profit-sharing under Interest-free Banking
In an interest-free economy, conventional interest-based banking

is supplanted by interest-free banking transactions. Both Iran and
Pakistan have passed laws requiring their banking system to operate
without invoking interest payments in any transactions. In consequence,
the alternative system that has evloved involves various forms of profit
and-loss sharing arrangements between banks and their depositors and
borrowers.
Islamic economists have frequently emphasized the unethical

nature of interest-based financial contracts whereby all the pressure
seems tobe on the debtor,
who must bear both therisk ofthe enterprise
and the burden of repayment. According to the Sharia'h, or Islamic law,
"both the provider of capital and the user of capital should equally share
the risk of new business ventures, whether these are industries, farms,
service companies, or simple trade deals. Translated into banking terms,
the depositor, the bank and the borrwer should all share the risks and
the rewards of financing business ventures", Khouri (1987). Accordingly,
Islamic banks around the world have devised several novel and flexible
instruments of
risk-sharing and profit-sharing: e.g. murabaha
(substitute for commercial bills of discount), mudaraba (investment
loans to business under a profit-sharing basis), marada (equity-based
bank bonds), musharaka (equity-based business lending), salam
(substitute for futures and forward-purchase contract), and many more.
Twopoints are worth noting in this innovative approach to

financial institutions. First, the nominal value of deposits, investment
loans (mudaraba and musharaka), or muqarada bonds is not guaranteed
under this system but is subject to ex post realization of returns in the
business enterprises financed by such instruments.0 Second, in the
absence of interest rates governing the demand and supply of investable
funds, the financial rate of return in enterprisebecomes the key
economic variable equilibrating the money, capital and goods markets.
High rates of return in certain activities will attract more financial
capital thereby lowering such rates. In consequence, it is conceivable

that under free market principles, the rate of return in all activities will
have a long run tendency to equalize. As can be seen, the rate that is pre
determined in this system is the PLS (profit-and-loss sharing) ratio set

114 Zaidi Sattar
by the bank. To theentrepreneur,this ratio is a givendatum so thathis

incentivefor investmentswill lie on his expectationof theprofitability
of
an enterprise.The following
may help illustrate
thispoint
Firms and entrepreneurs raise investible funds from two possible

sources:(a) first, there are 'mudarabah' loans from commercial banks.
These are interest-free loans whereby banks share in the profits of
enterprise at^re-determined rate,, say, b, which is called the bank's

rate of profit share. If 'p' is the entrepreneurs expected rate of profits,4
thebank's share of theprofitsis 'bp',while (1-b)p is thenet profitof the
entrepreneur. Losses, if any, might under some conditions be borne
entirelyby the lender,in accordancewith the rules of lendinglaid down

by the Shariah. The cost to the entrepreneur in that event is his time
and effort spent on a failed enterprise, (b) The second source of funds
arise from equity participation with the bank (musharaka) where both
equity capital and perhaps management is shared. The banks in turn

might float equity bonds (muqarada) to attract investors (firms other
than commercial banks, or even the central bank). The consequence is
the emergence of a stock market comprising of transferable instruments
wrhose "price and implicit rate of return are determined by market
forces", [see Khan and Mirakhor (1986)].
Banks, in turn, offer two types of accounts, deposit accounts and

mudarabah accounts. The former are like checking accounts but with a
nominal service charge to the deposit, while the latter make up the pool
of investible funds to support the lending operations of the bank.
Depositors with mudarabah accounts share in the bank's earnings (or
losses), once again, at a rate pre-determined by the bank, say, d. The
depositor's return is, therefore, 'dbp\
From the foregoing

analysis, it is evidentthatthefinancialrate of
return from investments, namely, the profit rate becomes a key
economic variable in an interest-free economic system. It is the
movement in the expected rate of profit that would affect investment
decisions, prices in the Islamic bond market, and the depositors' desire to
hold higher or lower money balances. It thus replaces the interest rate as
the key player in the determination of output and aggregate demand in
the Islamic economic system.
The role of interestrate in the Keynesian system is important

albeit not necessarily critical. Keynes himself had downplayed the role of
interest rates as the key determinant of investment levels, placing more
emphasis on such real macroeconomic variables as output, income, and
employment. The Keynesian transmission mechanism, however,

describesthe linkagebetween the demand formoney and the aggregate
demand for goods and services via calibration of interest rates.
Nevertheless, Keynes did express his reservation about the effectiveness
of interest rates as the link in the causal chain. The grounds of such
reservation were to be found in the interest-insensitivity of investment
demandand the notionof the 'liquiditytrap'associatedwith themoney
demand function - both of these arguments suggest the futility of using
interest rates as a policy tool formacroeconomic stabilization.
It is interestingto note that Monetarism, as a critique of
Keynesianism, opposed the idea of policy activism for the purpose of

short-term macro stabilization. Itwas money, however, and its growth
rate that replaced interest rates as the key determinant of prices, output
and economic activity. In the classical tradition, they argued (with
supporting empirical evidence) in favour of a one to one link between
money and aggregate economic activity in the long term.
In the
following sections, I propose the outlines of a
macroeconomic model for an Islamic economy, first in a static analytic
framework, using a variant of the Hicksian IS-LM technique, with fixed
prices. Later, the basic mdel is recast in a dynamic setting to examine

long run equilibrium in the steady state and the adjustment paths
following fiscal and monetary shocks in the Islamic economy.
The main purpose of this exercise is at present a formalised

aggregate description of the workings of an interest-free economic
system. Although a profusion of economic literature on Islamic banking

has recently appeared5, there has not been much effort at formal
macroeconomic analysis, Khan's (1986) pioneer work being the
exception. In a way, the present paper seeks to cover some of the
groundsthatwere leftout inKhan's paper.Hopefully,the analysiswill

demonstrate that an interest-free economic system can be formalised
within a neo-classical framework displaying most of the consistent
that are expected from such a model. As a model of the
properties

116 Zaidi Sattar
oftheanalysis lies in
Islamiceconomicsystem,theprincipalshortcoming
the fact that the microfoundations of aggregate economic behaviour
based on Islamic values are not thoroughly examined.
4. The Market for Goods and Services
At the outsetwe need to specifythe behavioral and institutional

assumptions that form the basis of an Islamic economy and society
These are:
(a) A majority of individualsbelieve in Islam and followitsprecepts

and practices as laid down in the Quran and Sunnah.
(b) The state pursues and social goals within

economic the broad
guidelines provided by the Quran and the Sharia'h.
(c) The institutionof Zakat exists as an integral part of the

economic structure. Zakat is a tax on non-human wealth levied
at a fixed proportion (2.5%) of net worth.
(d) Riba or any from of interest on credit is forbidden.
(e) The banking system intermediates between savers and investors

through various forms of profit-sharing arrangements.
These assumptions alongwith the individual as well social pursuit

for the attainment of 'falah' rather than utility or profit maximization
should exert a rather unique impact on the nature of aggregate demand
giving the Islamic economy certain distinctive features even within a

generally demand-based system. The building blocks for the model of the
goods market comprises the consumption, investment, and the
government expenditure functions. The specification of each will be

discussed in turn.
Consumption Function : The consumption function in general

functional formmay be written as
C = C (Y,W), dC/dY >0, dC/dW >0 (1)

+ +

Interest Free Economics & Islamic Macroeconomic system H?
where Y represents realincome, and W. non-human wealth like

earnings from physical and financial assets (e.g. musharakah
certificates), and any idle saving balances. It is the component of income
arising from non-human wealth that is subject to zakat Note that there
is no argument in the consumption function corresponding to the
interest rate as the only from of consumption loans permissible in an
Islamic economy are interest-free (qarz-Uhasanah), and there is no
parallel of an interest-sensitive bond market in this economy.
The specificlinearequation describingthe consumptionfunction

may then be written as
C - C0 + c(l-t)Y + a(l-z)W (2)
where C0 is subsistence level consumption. The induced consumption

expenditures result from current income (Y) net of taxes (t) and
household real wealth (W) net of zakat Household consumption is
expected to be keptwithinmoderate limitsset by the Sharia'h [seeM.
Arif, 1985,p. 95]. Since zakat is leviedon networth (whichincludespast
savings), the effect of accumulated wealth on consumption is described
by a (l-z)W. V is the conventional marginal propensity to consume out
of current income while V is the similar coefficient related towealth.
The specification of a consumption function that incorporates such

value constraints is beyond the scope of the present paper. As such the
specified form of the consumption function may be considered a close
approximation of the true form.
A word about consumption behaviour in an Islamic economy is in

order. The Quran has repeated by denounced any tendencies towards
overconsumption by the public, describing such inclinations as

extravagance or profligacy. Moderation in consumption habits has been
recommended while spending "above and beyond the moderate level is
considered 'israf and is1condemned." [Dr^Mtmzer Kahf, 1978, p.25].
Investment Function: The general form of the investment

function may be written as
I = I(p),ai/5p >0 3)

118 Zaidi Suitor
where p is the expected (realised)rate ofprofits.In its linearform , the

expression is
I = IQ+ ep (4)
where represents automous investments, and ep, the induced

I0
component.
The investmentfunctionis a criticalelement in thebuildingblock

and a proper understanding of the determinants of investment is
essential. The incentive to invest in an enterprise is provided by the
expected rate of return, i.e. the profit rate. Activities that offer the
prospect of higher profits will obviously attract more resources than
those that offer lower returns. The rate of profit share set by the banks
serve as the pro-rated financial cost* of investible funds and could deter
investments if set at a level too high. However, the central bank is in a
position to regulate the rate of profit share in order to ensure that

investment incentives are not unduly hurt since current and future
levels of economic activity are linked to investments. Although the rate
of profit share is crucial in investment decisions, it is not necessarily the
crucial variable to spur or deter investments.
forgoing illustrates the point that the PLS

The ratio is an
exogenous variable in the model, a given datum for the investor. The
elimination of a 'fixed cost' for investible funds thus introduce new
elements in the incentive system for an Islamic economy.
At this point, a caveat is in order. Some western economists [Piyor

1985] have argued that the elimination of the interest rate will have a
depressing effect on aggregate savings. Such an argument ignores
certain crucial facts about an Islamic economy: (a) there are ethical
limits on consumption so that beyond a certain level, all incremental
income will end up as savings, investments or zakat payments; (b) the
profit-sharing system is not necessarily, a disincentive for savings (c)

Muslims feel obligatedby religious convictionto save their surplus
income in interest-free accounts. Evidence from all the countries
experimenting with interest-free banking is unanimous that such a

system has had no debilitating effect on aggregate savings. [See, for
example, Khan and Mirakhor (1990)].

Government expenditure function : The

government expenditure
function must incorporate the notion of a welfare-oriented government
pursuing goals not only of economic developmentbut of distributive
justice and the ameliorationof distressamong its people. There is no
doubt that government spending from zakat revenues, which are
distinct from their tax revenues, must follow a counter cyclical pattern.
Such countercyclical variation in gove> ment spending is stipulated in
the following equation:
G = G0 + f(Y-Y),f >0 (5)
where G0 is the level of exogenous spending determined by

administrative and developmental needs, Y is a certain target level of
output (full employment),and T is a positive adjustment coefficient.

Thus the expression, f(Y -Y), incorporates the countercyclical nature of
public spending. In its general form, the function may be expressed as
G = G(Y),3G/3Y<0 (6)
Equilibrium : Setting aggregate demand equal to national income, we

arrive at the equilibrium condition
Y = C + I + G (7)
With appropriate substitutionof (2), (4) and (5) in (7), and

collecting terms, we obtain the equilibrium solution for the goods market
as
Y* = m [A0 + a(l-z)W + e(p) + f(Y) ] (8)
where m = Keynesian autonomous spending multiplier and
A0=C0 + I0 + G0
GG Curve : We now proceedto developeda simplemodel in the lines of

the Hicks-Keynes IS-LM. The model draws heavily from the IS-LM in
that it retains the crucial Keynesian assumption that output is demand
determined. Any disequilibrium in the goods market is resolved through
an inventoiy adjustment process that brings supply in line with demand.
Unlike the IS-LM, however, this model highlights the interaction

120 Zaidi Suttor
between the profitrate and output as aggregatedemand is driven by

variations in the profit rate.
we have
Settingtheequilibriumingeneralisedfunctionalform,
Y * C (Y,W) + Kp) + GOO (9)
we get
By totaldifferentiation,
dY = OC/3Y)dy+ (dl/dp)
dp + (3G/3Y)dy
Solving,
Y
Figure 1
Points above the GG curve represent excess demand (EDG).

InterestFree Economics& IslamicMacroeconomic system 121
while points below indicateexcess supply of goods (ESG). Changes in
bymovementsoftheGG curve.
fiscalpolicywould be reflected
5. Money Market and Portfolio Balance
Since the impactof interest-free

banking is feltdirectly in the
money market, researchers have paid considerable attention to the
operation of this market Controversy exists over the form of the demand
for money function, particularly with respect to the existence of
speculativedemand formoney.Metawally (1981) and al Jarhi (1981)
have produced conflicting evidence on the existence of speculative
demand for money inMuslim countries. The former finds no evidence
while the latter reports significant evidence of its existence. It is clear
that speculative demand, ifany, would have to be based on some average
rate of profit on investment which could also be reflected on the return
on instruments such as musharakah certificates.
To my mind, a transactions
demand model following BaumoPs
(1952) inventory approach would adequately serve our propose as such a
money demand function incorporates both The Notion Of the
opportunity costs of holding money as well as the convenient services
money provides it holders. Once again, it is the profit rate and its
changes that reflect the opportunity costs of holding money. At higher
expected rates of profit, individuals would seek to economise on their
holding of transactions deposits as it becomes more costly to do so.
Income and the profit rate thus become the main arguments of an
inventory-type money demand function as follows:7
Md = M(Y,p), dM/dY >0, 3M/3P <0

^10)
In its linear form,
Md=gY-hp, g>0, h>0 (ll)
Assuming the central bank sets money supply exogenously at M ,

122 Zaidi Saltar
we havemoneymarket equilibriumgivenby 8
M = M (Y,p) (12)
or M = -
gY hp(13)
we obtain
From (12), by totaldifferentiation,
di 3M/3p
> 0
dp mm dU/dY
Thus we have a positively sloped MM curve representing money
market equilibriuminp-Y space (Figure2).
Figure 2

Points to theright of theMM curve indicateexcess demand for

money (EDM), while points to the left represent excess supply ofmoney
(ESM). Note that the profitrate is impactedby changes in themoney
market, an excess supply of money reducing the financial rate of
return while an excess demand causing it to rise.
6. General Equilibrium.
This sectioninvestigates the process of simultaneous

determination of equilibrium in the goods and money market The
nature and properties of this general equilibraim will also be under
scrutiny.
In this interest-free economic system, the profit rate has emerged

as the critical variable linking the goods and money markets. The
algebraic solution of the system requires substituting the solution of 'p'
from(13) into (8). Equation (8) couldbe firstsimplified,
without loss of
generality,by lumping the terms withW and Y intoAo, yieldingthe
following modified equation:
Y - m fA0 + ep] (14)
Substituting the value of p into (14), collecting terms and solving

forY yields:
mh me
-- . -.
Y = Ao
- - Mo
h meg h meg
where A0 and M0 represent fiscal and monetary policy indexes. The
implications of (15) is that, given a level of money supply, fiscal

expansion, can raise output However, monetary expansion, by reducing
profit rates, cause output declines instead. This calls for complete co
ordination between fiscal and monetary authorities to achieve the goals
of economic policy. If the objective is to raise employment, the ideal
combination would be an expansionaiy fiscal policy associated with easy
money policy to keep profit rates from rising to 'unethical levels'.9
Stabilityof Equilibrium : The stabilityof equilibraimmay be

studied graphically under two alternative situation, namely,

124 Zaidi Sattar
Case I :GG curve is steeperthanMM
i.e. dY dY
dp IGG dp MM
Case :
II MM curve is steeper than GG
i.e. dY
. dY I
dp GG dp MM
Case I: In Figure 3, a unique equilibriumis achieved at Ej by

the intersectionofGG withMM such that the slope of theGG curve is
greater than that of MM. This yields the most desirable comparative
statics properties and a convergent equilibrium for any situation of
disequilibrium. The adjustment process and local dynamic are indicated
by arrows in Figure 3 and summarized below in accordance with
Dornbusch and Fischer (1984), in Table 1.
Figure 3

Table_
Region Disequilibrium Adjustment Direction
I EDG.ESM Yt.pi convergent
II ESG.ESM Yi.pi convergent

ni ESG, EDM Yi.pt convergent
IV EDG, EDM Yt.pt convergent
Case II : The casewhereMM is steeperthanGG stillproducesa unique

equilibrium but convergentequilibria in two of the four regions of
disequilibrium. That means the system could be unstable under certain
.
conditions.11
7. Macroeconoomic Policies and their Impacts
Analysis in the preceding sections have provided the basic

framework for examining the impact of macroeconomic policies. The
purpose in this section will be to analyses the combined as well as
unilateral consequences of initiating fiscal or monetaiy policies with an
eye on short-term stabilisation. It is worth noting that some of the
outcomes contrast sharply with conventional wisdom emanating from
western economic thinking and this will be emphasized in the ensuing
discussion of fiscal and monetaiy policies.
Fiscal and monetaiy institutions in Islamic economies (as well as

developing economies) in large part draw their authority from
government. Regardless of the consequences of their actions, there is
greater co-ordination of policies and closer commitment to the goals and
objectives of policies than is to be found in the developedmarket

economies. In the United States, for example, the monetary authority
(FederalReserve Board) acts independently
of the fiscalauthority(the
Congress) in taking monetary actions that affect economic activity.
Although close co-ordination and compatibility of goals is expected, it is

not surprising that often fiscal and monetaiy policies have been at cross
purposes with each other.12. Not surprisingly, therefor, a movement in
afoot in theUnited States to extractgreateraccountabilityfromtheFed
to ensure closer co-ordination of monetaiy policies with the overall
economic program of the administration.

126 Zaidi Saltar
At the conceptual level, the absence of interest-based government

bonds eliminatesa key instrumentof debt financingofbudget deficits
Also absent are some typical issues of debt management or open market
operations associated with easing the pressure on the loanable funds

market and hence interest rates. It becomes evident that monetary and
fiscal policies are no
longer independent options available to the
authorities. The close connection between the two is undeniable.
Budget deficits become

synonmous with monetary expansion. The
policy analogous to open market operations involves equity-based credit
expansion or contraction by the banking system as a whole, perhaps at
the instance of the central bank. Variations requirement of reserve
continue to be an instrument ofmonetary policy, however. Thus the only
forms of pure fiscal policy in an Islamic economy involve tax policies or
balanced budget changes of spending.
The notion of crowding out'is also strikingly different. First of all,

there is no parallel of the crowding out phenomenon experienced in
industrial market economies where the private and public sector must
borrow from the same pool of private savings. The only situation where
public spending could be expected to divert private sector investments is
when government expenditure increases are financed solely from tax
increases (as in the event of a balanced budget expansion) that depress
the rates of return on investments or in the equity-based financial
market.
Figure "4 presents a graphical analysis of fiscal-monetary policy

interactions in an Islamic economy.
From the practical standpoint, most fiscal expansions are likely to

be deficit financed and, therefore, fully accommodated by monetary
expansion. Fiscal expansion is reflected by GG' and monetary
accommodation by MM', such that the economy moves to a new
equilibrium from A to D with a higher level of income and possibly lower
profit rate. Point B indicates a scenario where fiscal expansion is
obtained by tax-cutting measure alone resulting in higher profit rates
and output. The economy's equilibrium, on the other hand, could result
from the over-liberalisation of equity-based credit which depresses profit
rates and becomes recessionary. Evidently, the best short-term results

GG /GC
Y0 Yi Y
Figure 4
for the economy are obtained through proper co-ordination of fiscal and
monetary actions.
8. Steady State Analysis and Dynamic Adjustments
We now proceed to extend the preceding analysis to cover the
economy's long run equilibrium in the steady state as well as trace the
possible adjustment paths following changes in the policy environment.
The basic behavioral assumptions about the goods and money markets
will be maintained. Whereas the previous model took no notice of price
changes, the ensuing model specifically incorporates a relationship

between inflation and wage-price pressure in the neo-Keynesian
tradition.
=
yd C(y) + I(p) + f (16)
> 0
Cy,Ip

128 Zaidi Sattar
Equatior ,16) is the aggregate demand equation expressed in

functional form. It shows aggregate demand as a function of real income
(y),the profitrate (p), and a fiscal index,f,whichwould ideallyrepresent

balanced budget changes in government spending. [See Blanchard
(1981) for a variation of this specification].
Dynamic adjustments in the goods market is described by
y = a( yd-y) (17)
where a >O is an adjustment coefficient. Equation (17) essentially

describes the evolution of output through a Keynesian inventory
adjustment process that is not atypical of an Islamic market economy.
Next, money market equilibrium is summarised in equation (18):
m = L(y,p) (18)
Equation (19) introduces a simple model of inflation where the

price level response to changes in output relative to full employment.
7T= - (19)
(y y)
since inflation has formally been introduced, equation

Finally,
(20) explains movements in real balances in response to changes in
nominal money growth ( ) and inflation (TT).
rh = - 7T(20)
By substitution, and assuming, to begin with, that monetary

=
authorities keep nominal money unchanged, (i.e. O), we obtain a
relationship between changes in real balances and output growth:
rh = - = -
(y
-
y) (20a)
Finally, to close the model, rational expectations will be assumed

in so far as people's expectations about fiscal and monetary policies and
their impact on prices and profit rates.

Stready state analyses presupposes money and goods market

= O and m ? O. Thus
equilibrium along with the properties, y (17)
yields
= O =
y C(y) + I(p) + f-y (21)
From (18), since p is an inverse function of m and y, (21) can be

expresses as
C(y) +I(m,y) + f-y =0 (22)
Total differentiation and collecting terms yields
MtI - Cy - Iv
dy 1y - cT-:-1 >< o
Im
The more plausible hypothesiswould have dm/dy <0 for

continuous goods market equilibrium since an increase in m depresses
profit rates creating an excess supply of goods which can be eliminated
througha fall in output.Figure 5 depictsa dynamicversion of theGG
(y=0) and MM (m=0) with the possible adjustment paths outside
steady state equilibrium (E0).
m
y y
Figure 5.

130 Zaidi Sattar
From (20a), lit fllowsthat rh=0 is verticalat y and points to the

left indicatem>0 and to the right,m<0. Adjustments in the goods
market implyy>0, (EDG) to the leftof y=0 and y<0 (ESG) to the
right.E is the steadystate equilibrium.It is evidentfromthe trajectories
ofmotions in the phase diagram, that the system exhibitswhat is
termed as "saddle point instability" [see Sheffrin (1983), p. 81. However,
following Samuelson's Correspondence Principle [Samuelson (1965)]

together with the assumption of perfect foresight, we snail locus only on
pathSS (thesaddlepath)13.
the limitingconvergent
Equipped with these phase diagrams, we are now in a position to

analyse the impacts of changes in the policy environment First, the
impact of a monetary expansion will be considered assuming such
expansion is the result of equity-based credit expansion by the monetary
authorities (Figure 6).
y y
Figure 6
Suppose the economy experiences the positive monetary shock at

A. This is depictedby a verticalshiftof the locusy=0 to yi = 0. The
initial impact is to depress profit rates (Figure 7), but over time, this rate
recovers to even off at steady state equilibrium as the economy adjusts

from B along the new saddle path.SS'14. The price level at is

obviously higher than at A.
Po
time
Figure 7
A fiscal shock implied by a balanced budget expansion or tax
cutting measure could be characterised by a similar shift of the locus
y=0 toy^O but the path of profit rates would be significantly different
as shown in Figures 8 and 9.

132 Zaidi Sattar
Figure 9

Curiously enough, the differentialimpactover time of the two

policy shocks is observed on the time path of profitrates, although
movements intheprice levelmightormight notbe different
9. Summary and Extensions
Nodoubt this has been a preliminary exercise at macro economic

model-building for an Islamic economic system. The interactions
between money, spending, output and the profit rate have been
highlighted for a system that lacks a key conventional macroeconomic
variable, the interest rate. The analytics of macroeconomic theory and
policy have been examined using standard Keynesian tools suitably
modified to conform to the workings of an interest-free economic system.
A critical outcome of the monetary-fiscal policy experiment was the
realization of close interdependence of the two policy instruments and
the need for complete co-ordination between monetary and fiscal
institutions for the achievement of short and long-term economic goals.
Clearly, logical extension to this model can be foreseen.

several
The emergence of the profit rate as the key variable in the Islamic
macroeconomic system raises the need for further investigations into the
formations of profit expectations and the specific influence of profit
sharing ratios on investment behaviour. Also at issue, from the moral

stand point, is the question of what level or rate of profits should be
determined as ethical.
This model is a demand-driven model.

The behaviour of aggregate
supply in response to changes in the profit rate needs to be incorporated
into the model and should be the next item on the agenda.
I concludewith the belief that interestand commitmenton the

subject is growingrapidlyand significant
productivitymay bewitnessed
in the near future provided sufficient encouragement is forthcoming
from institutions entrusted with the responsibility for fostering research
in Islamic economics.

134 Zaidi Sattar
NOTES
1. Abu-Saud's position is that interest rates on demand deposits are a sort
of bonus given by the bank to encourage depositors to keep their
money with it.
2. Mortgage (Rahn), according toAbu-Saud, is allowed in Islam without a

shadow of doubt. He cites the followingQuranic verse: "...and ifyou are
on a journey and do not find a scribe, Rihan (meaning wares in
mortgage or a pledge with possession) may be taken". (11:283). Upon
examination of this verse, however, my impression is that although
mortgage per se is permissible as a guarantee of future payment, there
is no mention in this or any other verse in the Quran allowing excess
future payment associated with this guarantee, - which indeed is the
case with real estate mortgages.
3. In contrast, under conventional banking, the nominal values of bank

deposits are guaranteed by the existence of a pre-dctermined fixed rate
of interest. Only their real values are subject to variation due to
inflation, though undoubtedly some expected rate of inflation is
presumed in setting nominal rates.
4. At this point, the assumption is that of perfect foresight,for simplicity,

such that p = pe (expected profit rate).
5. See, for instance, Khan (19S6), Khan and Mirakhor (1986),

M.N.Siddiqi(19S3).
6. Thc rationale for this is to be found inM.Arif (1985, p. 95). "If the
individual is unemployed, or his income is below subsistence, then the
Bait-ul-Mal will support him with the means to meet the subsistence
requirement".
7. Tobin's (1958) portfoloi balance approach would be relevant for an

Islamic economy that has a highly developed equity market as an
integral component of the financial system.
8. It can be shown that, for a given amount of real wealth, W. when the
money market is in equilibrium, the Islamic equity-based bond market
will also bc in equilibrium. Consider portfolio demand characterised by
Md+Bd = W while the economy's supply of such portfolio is given by
Ms+Bs = W. Thus (Md-Ms) + (Bd-Bs) = 0, implies equilibrium in the
bond market whenever Md=Ms.
9. In the Islamic economy, producers are not expected to be driven

entirely by profitmotive. Welfare maximization in the attainment of
may take precedence over profitmaximization. Thus it is the
'/a/a/z'
goal of private as well as public policy to see that profit rates are kept
within ethical limits.

10. See Appendix 'A*formathematical proof of stability.
11. When the slope of theMM curve exceeds the slope of the GG curve,
regions II or IV became non-convergent regions indicating the
possibility of explosive oscillations.
12. Recently (1980-82), the Federal Reserve Board pursued restrictive anti
inflationaiy monetary policy while the U.S. Congress was enacting
expansionary fiscal policies through higher spending and rising budget
deficits. The consequence was the U.S recession of 1981-82, the
deepest since the depression of the 1930s.
13. Samuelson (1965) has argued that itmakes no sense to do comparative

statics on unstable models. Interesting economic insights can often be
gained by assuming stability as is done in the present case.
14. It is necessary tomake the restrictive assumption once again that the
policy shock merely takes the economy into a new saddle path from
which the system converges to a new steady state equilibrium. Ej.
Explosive oscillations are thus ruled out of context.

136 ZaidiSattar
APPENDIX 'A'
The stability of equilibrium for thismodel may be demonstrated as follows:
Consider Total differentiation of equations (9) and (12);
dy -(Cy + Gy) dy +Tpdp(9a)

= + (12a)
dM0 Mydy Mpdp
Since money supply is expected to be determined exogenously by the central
= 0.
bank, we shall stipulate dM0 Then, inmatrix form, the above simultaneous
systemmay be expressed as
+ . 1
fCyGy ip* dy
(14)
My dp
The Ruth-Hurwitz stability condition requires that the determinant of the

cefficientmatrix be positive, i.e.
+ Ip
Cy Gy >O
y "*p
The expanded determinant isgiven by
+ -1) - >0
Mp (Cy Gy IpMy
Multiplying throughout by (-1),
- - + < 0
(I
Cy Gy) Mp IpMy
-
Or (I - < -
Cy Gy) Mp IpMy
Cy
< -
Ip Mp
Ip Mp
> -
I - Cy -
Gy My"
Thus dy dy
dp GG dp MM

REFERENCES
Abu Saud, Mahmud, Contemporary Economie Issues: Usury and Interest, Zakat
and Research Foundation, Cincinnati, 1986.
Ahmad, Khurshid, Economie Development in an Islamic Framework, The

Islamic Foundation, Leicester, UK, 1979.
Ali, A. Yousaf, The Glorious Quran. Translation and Commentary. American

Trust Publisher, 1977.
Arif,Muhammad, "Towards a Definition of Islamic Economies: Some Scientific

Considerations". Journal ofResearch in Islamic Ecnomics, Vol. 2, No.
2, 1405/1985.
Bamol, W.J., "The Transactions Demand for Cash: An Inventory Theoretic

Approach", Quarterly Journal ofEconomics, November, 1952.
Blanchard, 0., "Output, the Stock Market, and Interest Rates", American
Economics Review, March 1981, 132-143.
Branson, W., Macroeconomic Theory and Policy, Second Edition, Harper and
Row Publishers, New York, 1979.
Dornbusch, R. and S. Fischer, Macroeconomics, Third Edition, McGraw Hill,

1984, Ch. 3-4.
Hicks, J.R., "Mr. Keynes and the Classics: A Suggested Interpretation",

Econometrica, 1937, 147-159.
"A Monetary and Financial Structure for an Intercst-Frce

Al-Jarhi, M.A.,
Economy: Institutions,Mechanism and Policy".Papcr presented at the
Fllow-up. Seminar on Monetary and Fiscal Economics of Islam,
Islamabad, 1981.
Kahf, Monzcr, MAContribution to thc Theory of Consumer Behaviour in an

Islamic Society", in Khurshid Ahmad ed., Studies in Islamic
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Keynes, J.M., The General Theory of Employment, Interest and Money,
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INTEREST-FREE ECONOMICS AND THE ISLAMIC MACROECONOMIC SYSTEM

Author(s): Zaidi Sattar

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INTEREST-FREE ECONOMICS AND

The elimination of interest rates on bank loans, deposits and debt,

policy environment Using standard neo-Keynesian macroeconomic tools

suitably modified to conform to the workings of an interest-free

Department of Economics and Business, The Catholic University of

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This paper demonstratesthatmost of the desirablepropertiesas

experiment within the model reveals an intricate interdependence

Interest-based system of transaction and exchange has been the

It should be no surprise then that, following the injunctions of the

After several years of careful examination, in 1983, Iran

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non-Muslim countries of Europe

It would be follyto presume that the transformationof the

workings of an Islamic economy must therefore be based on rather strict

entirety) somewhat similar to the analysis of perfect competition within

equilibrium, its stability, and the adjustment paths traced in response to

policy changes. The standard neoclassical tools as well as the recent

approaches used in macroeconomic analysis will be adopted so as to

2. Rationale for an Interest-free System

"Allah has blighteth Riba and made Sadaqat fruitful".

The Holy Quran is categorical in its denunciation of the practice of

payment imposed on the debt. The pertinent issue, however, iswhether

arguments pertaining to the notion that interest is Riba and thereby

Mahmoud Abu-Saud (1986) has made an exhaustive examination

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prohibited in Islam is traditionally referred to as "Riba al-Fadhl", known

Upon close examination of the Quranic verses prohibiting Riba

What seems clear from his analysis

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3. Profit-sharing under Interest-free Banking

In an interest-free economy, conventional interest-based banking

Islamic economists have frequently emphasized the unethical

Twopoints are worth noting in this innovative approach to

capital thereby lowering such rates. In consequence, it is conceivable

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by the bank. To theentrepreneur,this ratio is a givendatum so thathis

Firms and entrepreneurs raise investible funds from two possible

enterprise at^re-determined rate,, say, b, which is called the bank's

entirelyby the lender,in accordancewith the rules of lendinglaid down

equity capital and perhaps management is shared. The banks in turn

Banks, in turn, offer two types of accounts, deposit accounts and

From the foregoing

The role of interestrate in the Keynesian system is important

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employment. The Keynesian transmission mechanism, however,

It is interestingto note that Monetarism, as a critique of

Keynesianism, opposed the idea of policy activism for the purpose of

prices. Later, the basic mdel is recast in a dynamic setting to examine

following fiscal and monetary shocks in the Islamic economy.

The main purpose of this exercise is at present a formalised

system. Although a profusion of economic literature on Islamic banking

exception. In a way, the present paper seeks to cover some of the

groundsthatwere leftout inKhan's paper.Hopefully,the analysiswill

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4. The Market for Goods and Services

At the outsetwe need to specifythe behavioral and institutional

(a) A majority of individualsbelieve in Islam and followitsprecepts

(b) The state pursues and social goals within

guidelines provided by the Quran and the Sharia'h.

(c) The institutionof Zakat exists as an integral part of the