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Macroeconomics within Islamic Framework (Advanced Level)

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### Macroeconomics within Islamic Framework (Advanced Level)

Dr. Sayyid Tahir

IIIE, IIU

IRIT, DL– 10 (17 Nov 2009)

The Target

- In DL-8 we focused more on conceptual matters such as Islamic economy, nature and role of government and economic policy.
- We also took note, albeit briefly, of the Islamic economics literature produced mostly in the 1980s and the 1990s parallel to that in the traditional macroeconomics.
- In DL-10 we take a comparative look at Islamic macroeconomics from an Islamic perspective and review some of the past analytical developments in the area.

Traditional Macroeconomics

- The target variables are Y, P, r (interest rate), N (employment), w (wage rate) and π (inflation)

---- Distribution issues are recognized but clubbed

under lump sum transfer payments

- The subject is concerned with description and prescription
- On the description side the economy is taken as it is.
- Nature & role of government + macroeconomic policy (both targets and instruments)
- The method of analysis: ‘As is’ approach

Macroeconomics in an Islamic Perspective (Islamic Macroeconomics)

- The target variables are likely to be Y, P, markup in deferred-payment contracts and profit-sharing ratio, N (employment), w (wage rate) and π (inflation) as well as poverty and inequality
- The subject is concerned with description as well as prescription.
- On the description side the economy is taken as either an “ideal Islamic economy” or “the existing macroeconomic setup as departure from the comparable an Islamic set up”
- Nature & role of government + macroeconomic policy (both targets and instruments)
- The method of analysis: ‘As is’ approach

Comparison

Traditional

The Islamic

Target variables

Description and prescription in the light of the Shari’ah principles

Nature and role of government and economic policy [with the maximum leeway for private initiative on both the economic and the distribution sides)

Method of analysis

- Target variables
- Description (on as is basis) and prescription (on the basis of good and bad)
- Nature and role of government and economic policy

4. Method of analysis

Ausaf Ahmad (1987 – 1983/4)

- A Model of Income Determination in an Islamic Economy (Jeddah: IERC, KAU, 1987)
- A pioneering work that sought to lay down foundation of Islamic macroeconomics
- The author consciously seeks to present Islamic income determination model against the backdrop of the simple Keynesian model.

Ausaf Ahmad (1987) – contd.

2nd Model:

Y = C + I + G

I = I0 G = G0

C = C1 + C2

C1 = a + b[Yd – Z – E] 0<b<1

C2 = Z + E

Yd = Y – T T = t.Y

Z = z.Y 0<z<1

E = γ.Y 0< γ <1

1st Model:

Y = C + I

I = I0

C = C1 + C2

C1 = a + b[Y – Z – E] 0<b<1

C2 = Z + E

Z = z.Y 0<z<1

E = γ.Y 0< γ <1

C1 and C2— consumption expenditures of the rich and the poor

Z and E — zakah and infaq going from the rich to the poor

Other symbols have their usual meaning.

Ausaf Ahmad (1987) – contd.

3rd Model:

I = I(Y, μ) (∂I/∂Y)>0, (∂I/∂μ)<0

S = I(Y, μ) (∂S/∂Y)>0, (∂S/∂μ)>0

S = I

Z = z.Y E = γ.Y μ is savers’ profit-sharing ratio

Analysis:

1. The author holds the view that Islamic economy is like the conventional economy except that there is the system of zakah and that interest is absent.

The 1st and the 2nd models: novelty in the consumption function. Results are expected.

3rd Model: Incomplete

Mohsin S. Khan (1986 - 1985)

- Mohsin S. Khan, “Islamic Interest-Free Banking”, IMF Staff Papers, 33(1), 1986, 1-27
- The focus is on monetary matters.
- The author seeks to establish three things:

(a) If Muslim countries move to Profit-&-loss-Sharing-

(PLS-) based that should not be a cause for concern

for policy makers at the international level.

(b) PLS-based banking is not an entirely new idea

(c) A PLS-based financial system is likely to be more

stable than the interest-based system.

(d) There would be no difference in the working of

monetary policy as at present.

Mohsin S. Khan (1986) – contd.

Assumptions:

- The economy consists of three markets: a market for goods, a money market and a capital market.
- All real income goes to capital rather than being divided between capital and labor.
- Banks are the only intermediaries. The savers deposit all their savings with the banks, and all investments in the economy are undertaken by borrowing from banks.
- When the savers deposit their saving with the banks, they essentially buy “shares” of banks whose nominal value is not guaranteed and the rate of return on them is not predetermined and can vary.

Mohsin S. Khan (1986) – contd.

Symbols:

y = real income (GDP)

r = real yield or real rate of return on shares

S = nominal value of shares

P = price level

s = real value of shares

Mohsin S. Khan (1986) – contd.

Capital Market:

Demand for Bank shares: s = S/P

Supply of Bank shares: y/r

Equilibrium condition: s = S/P = y/r

- Balance Sheet of the Banking System & Adjustment in the Capital Market:

Assets Liabilities

y/r S/P

When losses occur, nominal value of shares (S) is wiped off and the capital market instantaneously returns to equilibrium.

Mohsin S. Khan (1986) – contd.

Money Market:

- Economic agents hold their total real wealth (W) in the form of either real money balances (m = M/P) or shares of the banks (s = S/P).---P = 1 (constant). That is: w = m+s
- All money in the system (M) is outside money or currency supplied by the government.
- Working Hypothesis: People always maintain a constant ratio of real balances (m) to shares (s = S/P) that, in turn, is an inverse function of real rate of return (r):

m/s = g(r), g′ < 0

Money Market Equilibrium condition: m = g(r).s = g(r).[y/r]

Mohsin S. Khan (1986) – contd.

- Aggregate demand (yd) equals consumption demand (C) plus investment demand (I).

C = C(W, r), CW < 0, Cr > 0; W = m + s = m + (y/r)

I = I(r), Ir < 0

yd= C(W, r) + I(r)

- if producers are offered in real terms y, they would supply output worth y. Thus, ys = y

Goods Market Equilibrium Condition: y = C(Y, r) + I(r)

- Adjustment Mechanism: As usual.

Mohsin S. Khan (1986) – contd.

Real rate of return (r)

LM

B

r*

A

r1

C

IS

y1

y*

Real income (y)

The capital market remains in equilibrium by default.

Iqbal Mahdi and Mahyoub al-Asaly(1991 – 1987)

- Iqbal Mahdi and Saif Al-Asaly, “A Model of Income Determination in an Interest-Free Islamic Economy” in F.R. Faridi (ed.) Essays in Islamic Economic Analysis (New Delhi: Genuine Publications, 1991), pp. 52-66.
- Requirements of Isl. Economy are two: no interest and imposition of zakah.
- IS-LM framework adopted.
- Banks replace interest rate by PLS-ratio P that stands for “percentage of expected profit given to the bank as an equity owner in business” (p.57).---the percentage of profit going to the capital

Iqbal Mahdi & Al-Asaly (1991) – contd.

Equilibrium in the Goods Market – The IS Curve:

Y = C + I + Gt + GZ

C = f(Yd) f′>0 Yd = Y – T – Z

Z = z.S - - - - - - [Zakah is on savings.]

I = I(P) I′ < 0) - - - - - P is a PLS ratio

Gt and GZ are tax- and zakah-based government

expenditures, respectively (Exogenously given)

Equilibrium in the Money Market – The LM Curve:

Ms = Md

Ms = M0

Md = m(Y,P), (δm/δY)>0, (δm/δP)<0

LM

A

P*

IS2

IS

Y*

Y

Diagrammatic Analysis – Expansionary Fiscal Policy

P

LM

LM1

A

P*

IS

Y*

Y

Diagrammatic Analysis – Expansionary Monetary Policy

P

LM

A

P*

IS

Y*

Y

Diagrammatic Analysis

Iqbal Mahdi & Al-Asaly (1991) – contd.Zaidi Sattar (1991 – 1987)

- Zaidi Sattar, “Interest-Free Banking, Profit-Sharing and the Islamic Macroeconomic System” in F.R. Faridi (ed.) Essays in Islamic Economic Analysis (New Delhi: Genuine Publications, 1991), pp. 82-101.
- Assumptions: Closed economy with zakah, banks intermediating between savers and investors and a constant price level (=1).

Zaidi Sattar (1991) – contd.

Goods Market:

Y = C + I + G

C = C(Yd, W) CY>0, CW>0

I = I(p) I′>0

Yd = Y – T and T = tY, 0<t<1

Money Market (Price Level equals 1):

Ms = Md

M0 = M(Y, p) MY>0, Mp<0

p is “the expected (realized) rate of profit. G and W are exogenously given.----The analysis is based on linear versions of the various relations.

LM

p

(rate of return)

IS

Red Arrows: Direction of movement in “p” w. r. to excess DD/SS in the Money Market

Y (Real Income/output))

Green Arrows: Direction of movement in “Y” w. r. to excess DD/SS in the Goods Market

- Stability under Various Policy Scenarios: Results depend on slopes of IS and LM curves

Fahim Khan (1996 - 1992)

- M. Fahim Khan, “A Simple Model of Income Determination and Economic Development in the Perspective of Interest-Free Economy”, in M.A. Mannan (ed.), Financing Development in Islam (Jeddah: IRTI, IDB, 1996), pp. 79-108.
- Assumptions: A closed economy where the price level remains fixed. Zakah issues also do not apply.
- Investment is an inverse function profit-sharing ratio (a) while expected profitability of the enterprises in the economy (R) is exogenously given and remains constant.

The Model

Goods Market: Y = C + I + G

C = b0 + b(1 – t)Y

I = i0 – ia

Money Market: [M/P]S = [M/P]D - - - - - P=1

[M/P]S = [M/P]

[M/P]D = LA = kY – h′a

a = profit-sharing ratio for the owner of investment funds

h′ = a function of expected profits on financial assets; the said

expected profits are exogenously given

b0, b, t, i0, i and k are other positive constants with the usual restrictions on their size.

Analysis and Results:

- The LM curve becomes LAM curve, and the model an IS-LAM model.
- The LAM curve is presumed to have a horizontal segment at low levels of real income, an upward sloping part in the middle range and a vertical part at high levels of real income.----The three stages are taken to be synonymous with level of development.
- Conclusions about the effectiveness of the various are similar to those drawn in traditional macroeconomics in the income-interest rate plane.

Muhammad Anwar (1987)

- Muhammad Anwar, Modeling Interest-Free Economy (Va.: International Institute of Islamic Thought, 1987), pp. 27-60.
- Anwar presents a full-scale macroeconomic model that is a modified version of Sargent’s 1979 model.
- Assumptions:

(a) A closed economy

(b) The focus is purely on the monetary side of

the economy. ---- No zakah considerations.

Muhammad Anwar (1987) – contd.

Sargent’s 1979 Classical Model

Dr. Anwar’s 1987 Model

w/p = FL(K, L)

L = L(w/p)

Y = F(K, L)

C = C [Y - T - δK - {(M+Φ)/p}π + {η(K, L, k, θ, δ, π) - 1}.I; (kθ - π)]

I = I{η(K, L, k, θ, δ, π) - 1}

Y = C + I + δK + G (IS Curve)

[M/p] = m(k, Y) (LM curve)

w/p = FN(K, N) (Demand for labor)

N = N(w/p) (Supply of labor)

Y = F(K, N) (Agg. Prod. Func.)

C = C [Y - T - δK - {(M+B)/p}π + {q ( K, N, r - π, δ) - 1}.I; (r - π)] (Consumption Function)

I = I(q-1) = I[q(K, N, r-π, δ) - 1] (Investment Function)

Y = C + I + δK + G (IS Curve)

[M/P] = m (r, Y) (LM curve)

Muhammad Anwar (1987) – contd.

Interest-based Economy

r = rate of interest

δ = rate of capital depreciation

π = anticipated rate of inflation

r + δ – π = the user cost of capital

q = FK – [(r + δ – π)/(r – π)] + 1 = FK – {δ/(r – π)} = q(K, N, r – π, δ)

B = nominal value of outstanding bonds

Interest-free Economy

θ = normal profit rate in the economy

k = profit-sharing ratio of the financier

k θ + δ – π = the user cost of capital

η(K, L, k, θ, δ, π) substitutes q in interest-based economy.

Φ = nominal value of outstanding mudarabas

Muhammad Anwar (1987) – contd.

Results:

Similar to those of Sargent for his model of interest-based economy.

1. Fiscal effects on profit-sharing ratio (k), investment (I), consumption (C) studied.

2. On the monetary side, neutrality of money and dichotomy between the real and the monetary sectors endorsed!- - - -(pp.55-6)

Mohammad Hussain (1994)

- Muhammad Hussain, “A Comprehensive Macroeconomic Income Determination for an Islamic Economy”, The Pakistan Development Review, 33: 4 Part II (Winter 1994), pp. 1301-14.
- A full-scale model is presented with the demand as well as the supply sides.
- Assumptions:A closed economy with government, zakah factors and “the real rate of profit that an investor has to share with a financier-Rabb-ul-mal . . .” - - -The said rate of profit is both a factor price for obtaining money capital and opportunity cost of holding idle funds by the financier.

Muhammad Hussain (1994) – contd.

Demand Side of the Economy - The Goods Market:

y = c + I + g

c = c1 + c2

c1 = c[y – t(y) – z – e] c2 = z + e

t = t(y) z = z(y) e = e(y)

i = i(r) g = g0

c′, t′, z′ and e′ are supposed to lie between 0 and 1, and 0<(c′+t′+z′+e′)<1

Slope of IS Curve:–

[dr/dy]IS = [1 – c′ (1–t′ ) – (1 – c′ )(z′ + e′ )]/i′ < 0

Muhammad Hussain (1994) – contd.

Demand Side of the Economy - The Money Market:

[M0/P] = m = l(r) + k(y)i′ < 0, k′ > 0

Slope of LM Curve: [dr/dy]LM = – (k′/l′) > 0

Muhammad Hussain (1994) – contd.

Supply Side of the Economy:

Aggregate Production Function: y = NαK1–α

Equilibrium in Labor Market:

𝜕y/𝜕N = αy/N = w(N) w′ > 0

Equilibrium in Capital Market:

𝜕y/𝜕K = (1 – α)y/K = r

The three equations together yield equation of the YQ curve as follows:

y[α – {(1 – α)/r}(α – 1)/α.w(N)] = 0

Slope of YQ Curve (see also the diagram):

[dr/dy]YQ = – αr/(1 – α)y][(N2.w′ )/(αy + N2. w′ )]

Some Other Notable Mentions

- Mohsin S. Khan and Abbas Mirakhor, “The Financial System and Monetary Policy in an Islamic Economy” M.S. Khan and A. Mirakhor (eds.), Theoretical Issues in Islamic Banking and Finance, Houston, Texas: The Institute for Research and Islamic Studies, 1987.
- M.M. Metwally, Macroeconomic Models of Islamic Doctrines, London: J.K. Publishers, 1981. (see also JKAU, 1(1), 1983, pp.3–33, Arabic Section)
- There are also some works on consumption function and investment functions in an Islamic economy.

The Way Forward

- Reconstruct macroeconomics from the Islamic perspective.
- Basic Shift: We need to highlight the Islamic emphasis on distributive matters and bring in innovations on the financial side
- An Example: S. Tahir, “Towards a Theory of Aggregate Output, Income and Economic Inequalities Determination in an Islamic Economy”, Journal of Islamic Economics, 2(2), July 1989, pp. 95-108. (Originally 1985)

Assumptions:

Closed economy, constant price level (= 1), no financial considerations and exogenously determined distribution of income associated with the production process among Poor (the have-nots) and Rich (the haves)

Equilibrium Condition: Y = C1 + C2 + I + G

Degree of Inequality/Disparity D = [α1 – η1]/(α1α2)½

where η1 = [Yd1/(Yd1+Yd2)] and α1 and α2 are proportions of the poor (have-nots) and the rich (haves) in total population; α1+α2 = 1

Accounting Relations:

Yd1 = θ1Y + λY + δW + R θ1+θ2 = 1

Yd2 = θ2Y – λY – δW – T

------------- θ1 and θ2 are exogenously given.

Behavioral Relations:

C1 = A + aYd1 A>0, 0<a<1

C2 = B + bYd2 B>0 0<b<a<1

T = T0 R = R0 W = W0

I = I0 G = G0

Notable Features of the Model:

- Disaggregation introduced in the aggregate consumption function. MPC of the Poor > MPC of the Rich.
- The poor (the have-nots) are those who receive zakah paid by the rich (the haves). Zakah is paid on the output flows (such as agricultural and mineral output—a component of Y) as well as wealth carried over from the past (W). Proportions of the poor and the rich in total population, respectively, are α1 and α2. Moreover, α1+α2 = 1.
- The rich also pay taxes, and the poor also receive transfer payments. Both of these are exogenously determined.
- Taxes and transfer payments are kept in the model in order to underscore the point that there may be taxes and transfer payment in an Islamic economy. The latter would arise

The Solution:

Ye = ψ1E + ψ2Y

where E = A+B+I0+G0+aR0-BT0

ψ1 = 1/[1-(θ1a+θ2b)-λ(a-b)] (expenditure multiplier)

ψ2 = δ(a-b)/[ 1-(θ1a+θ2b)-λ(a-b)] (wealth multiplier)

De = [α1 – η1e]/(α1α2)½

Policy Analysis:

Besides the traditional fiscal policy analysis, one may also explore Islamization of economy as an economic policy.

- Read the model while suppressing the zakah parameters λ and δ, and re-calculate the equilibrium values of Y and D, say Yp and Dp.
- Compare Yp and Dp with Ye and De derived earlier and draw the necessary conclusions.

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