( No : 13 /2010 )
1. INTRODUCTION
In monetary economics, monetary policy is a key aspect of public policy for managing
the economy. The Bank1 is given the task of conducting the monetary policy to promote
monetary and financial stability and, hence, to produce a conducive environment for
attaining sustainable growth of the economy. In Malaysia, the financial system consists of
the conventional financial system and the Islamic financial system. The latter is
prohibited from receiving and paying interest. The question arises as to how monetary
policy would be conducted in the absence of interest, which is currently both a tool of
monetary policy and the choice of monetary variables to be controlled.2 The question is
especially important when the interest rate is used as a benchmark for Islamic financial
transactions. For example, Choudhry and Mirakhor (1996) and Masood Khan (2004)
mentioned that the interest rate is 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 the Islamic banking system may change the transmission of monetary policy.
This issue has not been touched yet. The prohibition of interest not only has implications
for the working of monetary policy (including the financial system) in a dual financial
Abdul Ghafar Ismail is Professor of Banking and Financial Economics, School of Economics, Universiti Kebangsaan
Malaysia. He is also a Research Fellow at ISRA and AmBank Group Resident Fellow for Perdana Leadership
Foundation. He can be contacted at agibab@ukm.my.
1
Please refer to the Bank of Malaysia Act, gazetted on September 2009. Although the Act refers to the Central Bank
of Malaysia as CBA, it also refers to it as the Bank. The Bank of Malaysia is also known as Bank Negara Malaysia.
2
Sometimes we can call this variable an intermediate target.
1
ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
system but also the relations between depositors and banks and between banks and
entrepreneurs.
There remain questions about the choice of monetary policy tools. Basically, there are
two financial system designs. Both models incorporate, to varying degrees, the principle
of profit sharing with depositors and entrepreneurs. The first model relies exclusively on
the profit-sharing principle for both assets and liabilities. In the second model, there is a
mix 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 a discussion of the theoretical basis for the operational target of monetary
policy. In determining the target of monetary variables, both the short-term interest model
and the reserve position will be presented in Sections 4 and 5, respectively. In Section 7,
the focus will highlight on the lessons from the Reserve Position Doctrine. Finally,
suggestions on the choice of the monetary target for the Islamic banking system will be
put forward in Section 8.
2
Tools for Controlling Monetary Variables in the Islamic Banking System
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 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 an excess or deficiency of liquidity.
In principle, Islamic banks must maintain their Statutory Reserve Accounts balances at
the Bank at a level that is at least equal to the prescribed ratio. 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 fulfil 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.
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ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
managing their liquidity while, at the same time, ensuring that no Islamic bank behaves
imprudently by allowing their reserves on any given day to fall too far.
- 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.
3
The example for calculating SRR is given in Appendix A.
4
Tools for Controlling Monetary Variables in the Islamic Banking System
The short-term objective for open market operations is specified by the Banks Monetary
Policy Committee (MPC). The Banks 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 murabah 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 murabah inter-bank investment transactions.
The decline in murabah transactions was also attributed to stable liquidity conditions
and the average rate of returns offered in the murabah inter-bank investment
transactions.
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ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
The Bank can also state its target level for the murabah inter-bank funds rate. It can do
so through their meetings, which usually include the MPCs assessment of the risks to 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.
The overnight policy rate is the murabah inter-bank fund rate paid by Islamic banks
and other Islamic depository institutions on financing they receive from the Banks
financing facility.
6
Tools for Controlling Monetary Variables in the Islamic Banking System
Under the facility, financing is 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.
For example, in the first part of 2007 the MPC decided to keep its target for the
murabah inter-bank funds rate at the level of 3.5 percent due to slower economic
growth in that period 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, the high level of resource utilization had the
potential to sustain those pressures. This might influence the margin rate for murbaah
financing.
From the above discussion, a monetary policy tool is a tool available to the Bank to use to
reach its operational target. Today, the Bank uses three such tools, namely reserve
requirements, overnight policy rate, and open market operation.
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 the 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 Banks decision-making body. Although, the Bank appears
to have followed such an approach in practice most of the time, academic economists
during most of the 20th century favoured a rather different approach to defining the
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ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
operational target of monetary policy.4 The approach still remains the subject of great
debate in textbooks on monetary economics. The textbooks contain many references to
Reserve Position Doctrine (RPD) concepts; for example, substantial space is devoted to
the money multiplier.
It seems that both RPD and the short-term interest rate model (STIR)5 have contrasting
views. Before the debate goes further, this section will briefly define the concept of an
operational target of monetary policy and review the possible specifications of
operational targets. The concept of an operational target needs to be distinguished clearly
from two other concepts: tools of monetary policy and intermediate targets. The
following definitions of the two terms are proposed here. (Monetary policy tools have
already been discussed.)
The operational target of monetary policy is an economic variable that 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 level of this variable that 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
as to what must be done 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
4
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.
5
STIR will be discussed in greater detail on page 13.
8
Tools for Controlling Monetary Variables in the Islamic Banking System
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 of mixing them up through imprecise usage. Poole (1970), by raising the
question whether to use 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 favour 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 to maintain
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 it has invited academics to
work on the same imprecise lines over decades. The extensive related literature has been
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
9
ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
operational targets role of communicating 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 others, for example, the Bank of
England and the European Central Bank (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). 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 the press release of 19 March, 2001 announcing the policy). The Bank
of Japans 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 cases of the ECB and
the Bank of England suggest, explicitness does not seem to be a necessary
condition for an effective communication of the monetary policy stance to the
public.
10
Tools for Controlling Monetary Variables in the Islamic Banking System
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 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, for example, by Anderson (1969). According
to him, in the 1960s there were 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
11
ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
interest rates should be zero, and within that setting, the operational target is
defined in terms of an (excess) reserves target.
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 that is really most relevant in
influencing decisions of key economic agents (consumers, investors, etc.). According to
Borio (1997), in his sample of 14 central banks of industrialised countries, eleven used an
overnight interest-rate target; one used a 30-day interest-rate target; and two used
interest-rate targets of 30-90 days. Since then, the three dissenting ones (Belgium,
Netherlands, UK) have all 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-day 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-day 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 changes that were well anticipated. Both features would today be deemed to be
suboptimal, as they conflict with the aims of simplicity and transparency.
12
Tools for Controlling Monetary Variables in the Islamic Banking System
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 ratesi.e., those judged to be most relevant for monetary policy
transmissionwill 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, with everything else unchanged, white noise in any
price does not add value, but creates (maybe very small) incentives for market players to
invest in 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, does it become 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 to strictly control 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, who did not
want to get into the details of day-to-day monetary policy implementation and
the implied need to split up further the monetary base into sub-elements.
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ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
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, for example, Meigs, 1962).
1970s X X X SID
1980s X X X SID
1990s X X X SID
2000s X X X X SID
14
Tools for Controlling Monetary Variables in the Islamic Banking System
While the Bank relies on interest rate targeting in the context of monetary policy, it still
needs a way to choose the target level of the 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 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.
The Taylor rule states that:
Interest rate target = inflation + Real equilibrium interest rate + (1/2) Inflation gap + (1/2)
Output gap
= + + +
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
15
ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
logarithm of real GDP, and is the logarithm of potential output, as determined by a linear
trend.
In calibrating this rule, lets 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%, the inflation gap will
be 4% 2% = 2%, and if 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, McCallum (1993) introduced 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:
= + 1.5 + + 0.5
where
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
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.
6
These gaps reflect the concerns of the Banks MPC regarding both inflation and real output fluctuations.
16
Tools for Controlling Monetary Variables in the Islamic Banking System
The explanation of the above formula is as follows. Let, we define the velocity of (base)
money, V, by
=
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
= +
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ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
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
=
16
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 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
= 0.0075
on a quarterly basis. He expects the Bank to choose an inflation target of 2 percent per
year which amounts to
= 0.0050
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
= 0.5 + +
18
Tools for Controlling Monetary Variables in the Islamic Banking System
then the result is McCallums 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.
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 the 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 transactions in the Islamic
banking system. Taylors rule might need to be re-evaluated because the final impact is
on the volume of financing that comprises the cost of acquiring assets and the profit
margin that has an impact on the price level. Hence, if the Bank changes the benchmark,
the amount of financing for particular years would also change. In addition, the amount
of financing (over time) could also capture the price level. Since the inflation rate tends 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:
7
Through the multiplier effect, an increase in financing would increase the money supply.
19
ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
if inflation appears to be above the target, the Bank is likely to reduce interest
rates. (In the conventional approach, the Bank is likely to increase the interest
rate because inflation and interest rates are inversely related.) This usually
(but not always) has the effect over time of cooling the economy and bringing
down 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, 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 inflation rate.
Therefore, the benchmark and the inflation rate are positively related.
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, Japans
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, Canadas is
2.25 percent and the euro zones is 2.5 percent. As the fallout from the global crisis
worsens, these and many other benchmark rates will edge toward zero.8
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/
20
Tools for Controlling Monetary Variables in the Islamic Banking System
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 hits the lower bound of the ZIRP,
governments 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.
The current debate on Reserve Position Doctrine can be discussed according to three
different views, i.e., Keynesian, Monetarist and Islamic Economists.
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 at or close to zero
and 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
enthusiastic support for RPD by Keynes, mainly in the second volume of his Treatise on
Money of 1930. This support seems surprising today, for 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 for 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
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ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
of England. Thus, praising RPD was also an additional way for Keynes to attack the
Bank of Englands 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:
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 contact with
money markets since at least 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, anyone 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 banks 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
22
Tools for Controlling Monetary Variables in the Islamic Banking System
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 a 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
that of many central bankers of the 1920s. Finally, it is worth noting that Keynes also
promoted the idea of actively using 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 reserves at the Bank.
23
ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
the power of control in the hands of the Bank of Englandplacing, indeed, in its hands
an almost complete control over the total volume of bank moneywithout in any way
hampering the legitimate operations of the joint stock banks. This argumentation was
taken up by central banks; for instance, the Board of Governors of the Bank of England
listed 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
per cent, effective September 1, thereby releasing about $125 million of
reserves.
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 in preventing
RPD from being silently buried already in the late 1960s.
24
Tools for Controlling Monetary Variables in the Islamic Banking System
Perhaps the 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:
What may be most striking in Friedmans (1960) analysis is his silence on the role of
short-term interest rates and in particular about the fact that his proposals would imply
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 per cent to a rise of 6 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.
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ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
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.
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 Feds 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 Reserves early
history largely from an RPD perspective, and argues, without a reference to interest rates,
26
Tools for Controlling Monetary Variables in the Islamic Banking System
that (pp. 62-63) a complete theory of the monetary system requires studying all aspects
of the monetary base (and its components).
Todays central bankers are likely to reject the monetarist approach to the choice for the
operational target of monetary policy as just one more, and even particularly reality-
distant, variant of RPD. Despite that, 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.
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
27
ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
Imam Ghazali (1058-1111 CE), Choudhury (2005) and Ahamed Kameel (2002), to
whom Islamic economists owe a great debt for their contributions to monetary theory,
have consistently stressed the importance of money as a medium of exchange and the
importance of banks in facilitating its exchange. Their contribution could also be seen in
treating money as capital. Due to this, the latter two authors disagree on the imposition of
fractional reserves on Islamic banks.
Although RPD has been established since Day One of the modern banking system, the
doctrine is not without critics. In this section, several lessons will be highlighted.
28
Tools for Controlling Monetary Variables in the Islamic Banking System
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.
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, acting as lender
of last resort to banks.
The initial discussion, as reported above, has shown that there are two channels through
which monetary policy changes affect economic activity and inflation. These two are the
interest-rate channel and the 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 structural components of the financial system could alter the monetary
29
ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
As a result, the financial system design processes prompt us to reassess 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
the capital market plays a predominant role in channelling funds to the economy. The
new financial landscape and financial reforms undertaken to the 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 have 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 effective 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 the banking sector) play an important role in monetary transmission to
uphold the conduct of monetary policy in the dual banking system in Malaysia.
30
Tools for Controlling Monetary Variables in the Islamic Banking System
7. SUGGESTIONS
In this section, we suggest the following tools for the working of monetary policy.
The higher inflation rate might be reduced by reducing the interest rate. However, the
reduction in interest rate is not effective if it reaches the zero level. The effective way is
to emphasise fiscal policy, but this might increase the level of budget deficits. Therefore,
both policies might produce an unhealthy and unsustainable economy. The real
prescription is to move to profit-sharing ratio policy.
In the profit-loss-sharing mechanism, any profit generated comes from the revenue. This
revenue is derived from the quantity sold and the price level. Since the price level is
determined by supply and demand, if the price level is high enough, it will generate profit
for the entrepreneur (after cost deduction), which will later be shared between the capital
provider and the entrepreneur. Therefore, the percentage shares of the profit-sharing
mode of financing might offset the increase in the price level, which is due to changes in
the 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 = xt vt
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ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
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).
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 are 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 of a
10
The model of fractional reserves has not been imposed on non-banking institutions.
32
Tools for Controlling Monetary Variables in the Islamic Banking System
100% reserve ratio. The main reason is the counter-inflationary effect of Islamic
financing. However, it may 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 create money endlessly. 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 loan and not for the interest, the banking system as a
whole must continually increase the overall amount of debt; otherwise the economy will
collapse. The fractional reserve system is why house prices, for example, have been
rapidly rising all around the world, and some form of bust is inevitable.
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 economys need for credit to be made available for productive investment.
Thus, banks would become essentially depository and investing institutions that 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 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
33
ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
The typical structure of uses and sources of funds in Islamic banks shows that they can
influence the economy via three important monetary variables: financing (i.e., for capital
and consumption as well as the government budget); deposits (i.e., as part of the money
supply) and investment.11
8. CONCLUSIONS
The aim of this paper is to identify the tools for controlling the monetary variables in an
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 the Short-
Term Interest Rate Model and the 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 an Islamic banking system.
11
The typical balance sheet of an Islamic bank is shown in Appendix B.
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Tools for Controlling Monetary Variables in the Islamic Banking System
REFERENCES
Ahamed Kameel Mydin Meera. (2002). The Islamic gold dinar. Kuala Lumpur: Pelanduk
Publications.
Ayuso, J. and R. Repullo. (2003). A model of the open market operations of the European
Central Bank. Economic Journal, 113, 883-902.
Bagehot, W. (1873/1973). Lombard Street, in: The collected works of Walter Bagehot.
London: The Economist.
Borio, C.E.V. (1997). Monetary Policy operating procedures in industrial countries. BIS
conference papers, vol. 3, 286-368. Basle: BIS.
Dow, J.P. (2001). The demand for excess reserves. Southern Economic Journal, 67, 685-
700.
Friedman, M. (1960). A program for monetary stability. New York: Fordham University
Press.
Friedman, M. (1982). Monetary policy: theory and practice. Journal of Money, Credit
and Banking, 14, 98-118.
Goodhart, C.E. (1989). The conduct of monetary policy. Economic Journal, 99, 193-346.
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ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
Gordon, H.S. (2002). The Changing U.S. Financial System: Some Implications for the
Monetary Transmission Mechanism. Federal Reserve Bank of Kansas City
Economic Review, 87(1): 5-35.
Keynes, J.M. (1930/1971). A Treatise on Money, 2nd volume: The applied theory of
money, in: The collected works of John Maynard Keynes, Vol. VI. London:
Macmillan/Cambridge University Press.
Masood Khan, W. (2004). Transition to a Riba Free Economy. New Delhi: Adam
Publishers and Distributors.
Masudul Alam Choudhury (Ed.). (2005). Money and Real Economy. New York: Wisdom
House Academic.
McCallum, B.T. (1993). Specification and analysis of a monetary policy rule for Japan.
Bank of Japan Monetary and Economic Studies, November, 1-45.
Meltzer, A.H. (2003). A History of the Federal Reserve, Volume 1: 1913-1951. Chicago:
University of Chicago Press.
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Tools for Controlling Monetary Variables in the Islamic Banking System
Raghavan, M. V. (2000). The changing Malaysian financial environment and the effects
on its monetary policy transmission mechanism. Melbourne, Australia: RMIT
University, School of Economics and Finance.
Walsh, C. E. (1998). Monetary Theory and Monetary Policy, Cambridge, Mass.: MIT
Press.
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ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
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:
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)
38
Tools for Controlling Monetary Variables in the Islamic Banking System
The table below shows the differences between the balance sheet of Islamic banks and
conventional banks. One of the major differences between an Islamic bank and a
conventional 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 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 mushrakah and murabah. 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
the principal of these funds as well as their fixed (pre-determined) interest rates are
contractually guaranteed.
The review of the daily analysis of an Islamic banks 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 boards 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.
39
ISRA Research Paper (No. 13/2010) Abdul Ghafar Ismail
Assets Assets
Liabilities Liabilities
Source: Abdul Ghafar Ismail. (2010). Money, Islamic Banks and the Real Economy.
Singapore: Cengage Learning.
40
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