Islamic Monetary Economics: Insights from the Literature

Abstract

This chapter reviews critical early literature of Islamic monetary economics. The prohibition of riba has imposed challenges on Islamic economists to come up with the viable alternatives to achieve Islamic monetary policy goals. Our extensive review of theoretical and empirical literature indicates that equity-based profit and loss-sharing instruments have been proposed for conducting open market operations in an interest-free economy. Theoretically, the central bank can achieve desired goals by controlling money supply and profit-sharing ratios. The findings from empirical literature suggest that money demand tends to be more stable in an interest-free economy. Whether monetary transmission works through Islamic banking channel is controversial, but the literature is growing. Since Islamic banking tends to mimic conventional finance, the transmission mechanism works through the rate of interest. These findings are not surprising as Muslim-majority countries lack sustainable and equitable economic growth. Moreover, these countries suffer from higher inflation and unemployment with little or no monetary freedom due to fixed exchange rate regime, shallow financial markets, and strict capital control.

An earlier version of this paper was published as a working paper in Munich Personal RePEc Archive MPRA Paper No. 72081.