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HomeISFIRE Vol 11– Issue 3 June 2021Monetary Economics - Pitfalls and Opportunities for Islamic Economists

Monetary Economics – Pitfalls and Opportunities for Islamic Economists


In the modern world, the fortune of nations crucially depends on the monetary system of their countries. If the good management of the monetary system leads to prosperity and development, bad management may lead to economic recessions and disasters. Many events of significance in economic history are linked to monetary management. Economic theorists such as Keynes and Freedman agreed that the Great Depression of 1929 resulted from monetary mismanagement. To prevent a similar fate, these great economists prescribed two different solutions to manage the monetary system.

Despite their guidance the monetary economist has always taken the whole discipline very casually. The literature on the monetary system is full of misconceptions, wrong assumptions, averse to database evidence, logical inconsistencies, and socio-economic implications. The example of the Great Depression shows that the monetary system is closely linked to the socio-economic indicators and their normative implications. Unfortunately, the monetary authorities worldwide usually ignore the normative implications of socio-economics when analysing the monetary policy.

Mainstream monetary economics is based on several non-realistic assumptions, a fact that is now well documented. The irony is that these assumptions are unrealistically followed and validated. Even in advanced countries, there is a disconnection between monetary economics taught in textbooks and the one actually practiced. On the other hand, third-world countries are still clinging to the textbook version of monetary economics. One of the reasons could be the pressure of the international financial institutions on underdeveloped and developing countries to follow textbook-defined monetary economics. In corollary, these approaches have given rise to an unrealistic and assumptive monetary system in most cases.

This dichotomy in the pursuance of the monetary system has led to increased inequalities and economic hardship in developing countries. The international financial institutions and the textbook literature discourage developing countries from borrowing from their central bank, considering it a significant inflation source. On the other hand the developed countries are allowed to borrow from their central banks without qualms. During the pandemic, while the developing countries were instructed to practice austerity and fiscal discipline, the developed countries were supporting their people against the coronavirus-induced economic hardship by borrowing trillions of dollars from Central Banks.

This brief article outlines the problems in the monetary system, the reaction of the advanced nations to the problems and the role of international financial institutions during the pandemic. It also highlights the opportunities for Islamic economists in this context.


Monetary policy often takes a route based on flawed logic and false assumptions. For example, since the very beginning price stability has been one of the objectives of the monetary policy and has been considered the core objective in the inflation-targeting framework. Though the price level per se could not be an objective, especially, when the monetary system is based on fiat money, there are implications that could not be avoided. Therefore there must be some reasons why the authorities concerned made the price level target of the monetary policy.

The aggregate consumer price index does not imply anything. It is the wage prices versus commodity prices, fuel prices versus food prices, and urban price index versus rural price index that carry real implications. For example, a popular theory relating the price level to the actual variables is the Phillips Curve theory, which says higher inflation leads to higher employment. This theory is based on the assumption that commodity prices usually drive inflation, and the wages are relatively rigid, which do not instantly respond to the prices of commodities. When commodity prices goes up and wages are fixed the employer taking benefit of the situation increases production and hires more labour. It means the effect of inflation on employment depends on the relative movement of commodity prices and wages. Suppose the commodity prices, wages, and all other price indices grow at the same rate, there will be no advantage for the firms to produce more, and the employment will not increase. Similarly, if inflation occurs due to any other price sub-index, the implications may be quite different. For example, it happened in the 1970s when an increase in oil prices led to increased production costs. Such an increase in the cost of production gives no advantage to the firms to hire more workers. Therefore there was no Philips Curve effect resulting from this inflation. This phenomenon was termed stagflation.

The whole monetary economics targeting inflation or the price levels are based on false logic

The above discussion implies that if monetary authorities target any real variable, they should focus on the relative movement of the price sub-indices instead of focusing on the aggregate level of prices. However, it is hard to find any mention of the relative movement of the price of sub-indices in the literature on monetary policy. This implies that the whole monetary economics targeting inflation or the price levels are based on false logic.


As for the famous Phillips Curve theory, when the employer fires unwanted workers to stabilize prices, in the case of reduced inflation, it is the daily wageworker or the temporary employees who are hit the hardest. People with resources manage to sail through such hard times. Therefore price stability comes at the cost of job losses of the vulnerable segment of society. It also stymies the progress toward several sustainable development goals, including reducing poverty, providing decent jobs, and reducing inequality. Should a sensible public institution take such actions, which create difficulties for the most vulnerable segment of society?

Look at a similar problem from another angle; the demand channel says the monetary policy can reduce inflation by reducing aggregate demand. However, if aggregate demand reduces, it shall only be for luxuries products. This is because the price level does not affect the products of everyday use. Therefore, any reduction in the price level will benefit those having luxuries in their consumption basket. Therefore, the relative income of the high-income segment will increase as compared to the under-resourced segment. In this way, the monetary policy may lead to redistribution of relative income in favor of the privileged class.

Being the signatory of the sustainable development goals, it is the responsibility of every government to adopt the policies leading to the achievement of SDG. However, intuitive analysis of the monetary policy indicates that the monetary policy may lead the nations away from sustainable development goals.


Monetary economics, as it is practiced today, is based on the Demand Theory of Monetary Transmission. The demand channel says that to reduce inflation, the monetary authorities should adopt contractionary monetary policies. It means either the money supply is reduced or the interest rate is increased to bring the demand for goods and services down to achieve equilibrium in the price level. We have several examples where a reduction in the interest rate did not affect inflation and neither an increase in interest rate led to reduced inflation.

For example, in March 2020, after the pandemic, the United Kingdom reduced the policy rate from 0.7% to 0.1%. By this reduction, one expected a hike in the price level. However, this was not the case; in fact, it was the other way round, inflation came down and had been so till March 2021. This means that under certain circumstances, the demand channel changes behaviour. Since monetary policy is a serious business, which determines the fate of nations, there must be mention of such conversions in the discussions of central banks. However, unfortunately, one rarely finds such discussions in the central bank documents.


Monetary authorities often behave like religious activists and deny anything, which is not consistent with their beliefs. There are implications of every channel used in developing monetary policy. For example, the demand channel predicts that increasing the interest rate could reduce inflation, while the cost channel predicts that the interest rate hike could increase inflation. However, like the followers of a religious sect, the documents of central banks will only follow the prescription of demand channels, ignoring the alternative ideas.

One of the oldest theories in monetary economics is the Banking School Theory pioneered by Thomas Took (1774-1858). He introduced this theory in the 1840s. This theory predicts a positive relationship between interest rate and prices. The logic is simple: the interest rate is part of the cost of production, and higher production costs will lead to a higher equilibrium price level. Instead of recognising the theory supported by data, the monetary economist ignored it and termed it a paradox or puzzle. In 1923 Gibson studied the data of 200 years to understand the relationship between interest rate and price. He found them to be positively correlated. It was such an incredible revelation that even John Maynard Keynes, one of the most prominent economists

of the 20th century, recognised its importance by terming it the “most established fact in the whole field of quantitative economics.” However, despite this recognition, he did not flinch from rejecting the observation as the Gibson paradox, probably because he knew nothing about the theory. Later, several heterodox theories were developed, reinforcing the views of Thomas Tooke, but they failed to find space in the monetary economics literature. Christopher Sims also provided solid empirical evidence to prove that the impulse response of inflation to the interest rate was positive, which meant that the actions of monetary policy based on the demand channel could be counterproductive. This observation was also labeled a price puzzle to prove that no theory could explain this phenomenon. Besides the Banking School Theory, the development of cost-side economics in the 1970s also supported the observation. Nevertheless, mainstream economics opt to ignore the alternate theories to support the mainstream idea prevalent in monetary economics.


The textbook economics says that increasing the money supply by 1% will lead to a 1% increase in the price level. However, this assumption proved wrong during the pandemic: The increase in money supply by as high as 10-20% did not lead to inflation. This implies that sometimes it is possible to borrow trillions of dollars from the central banks without sparking any inflation. One expected this practice to be replicated in the less developed countries as well so that additional taxes were not laid on people who were already suffering due to pandemics. However, the international financial institutions have been preaching the principles of no monetary expansion at this time of need.

During 2020, the supply of narrow money M1 in the United Kingdom expanded by 28%. Therefore, according to conventional wisdom, there should have been inflation corresponding to the increase in the money supply. But actually, the inflation in 2020 in the United Kingdom has been 0.4%, compared to 1.7% in 2019. Similarly, many other countries, including Germany, Canada, and the United States, borrowed heavily from their central banks regardless of the deteriorating ratio of central bank borrowing. On the other hand, the countries under the influence of IMF and other financial institutions have been practicing so-called fiscal consolidation, which is the opposite of the Quantitative Easing adopted by the advanced economies. Thus, for example, Pakistan retired 7 trillion worth of debt to its central bank during the pandemic, whereas the advanced countries were borrowing heavily from their central banks at the same time.

Undoubtedly, printing money in an uncontrolled fashion can spark inflation, as it happened in Zimbabwe and more recently in Venezuela. However, the evidence also shows that a considerable increase in the money supply under a controlled environment does not lead to inflation. Understanding this phenomenon is extremely important to use it to the advantage of people during a crisis such as a pandemic. Not using the option of borrowing from the central banks meant losing on the advantage of alleviating suffering in society without inviting inflation.


The advanced economies slashed their interest rates to zero to bring their economies out of the recession. It was equivalent to the fall of the inflation-targeting framework, which was the dominant framework in the 1990s and early 2000s. As a result, the interest rate as a tool to

control inflation became ineffective, making the low-interest rate a remedy to bring economies out of recession. In this context, there is a need to rewrite monetary economics built on the experiences gained during the global financial crisis and the pandemic.


The world has adapted to the quantitative easing framework as an alternative to the inflation-targeting framework. However, this change has given way to another kind of exploitation of the poor and unprivileged. Interest earnings have been one of the primary sources of revenues of the old aged from the middle and lower-middle class. Therefore when the interest rate is slashed to zero, the earning of these individuals becomes zero as well. Which means the borrower would not pay the lender even if it earns a lot from the borrowed money. This new kind of exploitation has made the pensioners and old age workers vulnerable. Moreover, under this environment of zero interest rates, people lose the incentive to save.

A more sensible and just solution would be to adopt profit-sharing arrangements such as Musharika and Mudarabah to distribute the resources even if nothing is earned on the investment. Unfortunately, as Muslim scholars, we have been unable to offer a workable solution to this predicament of monetary policy, especially when the existing Riba-based monetary system has failed. It is time for the Muslim economists to work seriously on developing a monetary framework based on the principles of Shari’a so that the second kind of exploitation which has started in the advanced economies could be stopped and a more just and viable solution for the monetary system is developed.


What is immediately needed is that the international financial institutions allow the developing countries to adopt the mechanism used by the developed countries. They lowered the interest rates and borrowed heavily from their central banks to alleviate the economic hardship of the masses through cash disbursements. Secondly, it is time for Islamic economists to propose a Shari’a-based solution so that every segment of society benefits from monetary policy action.


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