THE NATURE OF MONEY AND MONETARY POLICY

FOR ISLAMIC ECONOMIC INTEGRATION

Money, capital markets, financing instruments and the economy related to real sectoral
activities (i.e. productivity in a social and economic sense) are not detached phenomena
in the study of social well-being with complementarity among the relational variables.
Such a social well-being function is based on the cause and effect of the totality of
interrelationships among the entities mentioned in this chapter and more. Hence if this
interactive view on a relational order is to be accepted then one is led to inquire first into
the nature of money and its relationship with real economic activities.
The questions before us are the following:
Do existing theories and the nature of money therein establish a cause and effect
(i.e. causal interrelationships) between money, capital markets, financing instruments and
real sectoral activities, all factors that together define the social well-being function? Can
such interrelationships be at all possible with the existing theory and nature of money?
How is an alternative conception of money derived in relation to the social wellbeing function that in essence describes the causal and complementary interrelationships
among money, financing and real sectoral activities as a subset of a greater range of
socio-economic activities?
What are the institutional and policy implications of the two conceptions of
money and their relevance to the Muslim World towards establishing an ummatic
globalization in the new millennium?
Objective
Our objective in this chapter is to answer the above questions in an analytical
framework and thus to bring out the ineluctable note that the epistemological foundations
of the Islamic worldview allows only endogenous money to prevail and have meaning.
Such a meaning of money brings out the causal interrelationships in an Islamic social
well-being function. While investigating this premise we will show that the conception of
endogenous money is functionally different from both the exogenous nature of money in
received framework of macroeconomic theory and from the perceived nature of
endogenous money in other models of money and the real economy. The policy and
institutional ramifications within a globalization process with integrated capital markets,
factor markets and product markets are then derived.

A review of literature
In recent times, the usual writings by Islamic economists on money have been
primarily in the following areas:
A neoclassical idea of money in utility functions with issues of moral hazard and
Islamic ideas of risk aversion has been thoroughly used. The mudarabah (profitsharing)-musharakah (equity participation) contracts are then studied in the
background of such a neoclassical economic approach (Khan, 1985).
A further development of the above neoclassical perspective on liquidity
preference theory against the background of Islamic values is the Tobin-Brainard
q-theory of resource allocation. This has been used to study money with (Tobin &
Brainard, 1968; Khan & Mirakhor, 1989) or without international trade in the
model of money and economy (Zaidi & Mirakhor, 1991).
Then there is the usual study of money as a Keynesian entity. Such studies have
used the well-known static Keynesian models of IS-LM and of spendingmultiplier relations (Chapra, 1996; Choudhury, 1989a).
Neoclassical treatment of money and goods (real sectoral activities = economic core)
With regards to the neoclassical economic conception of money in the utility
function it is clear that the epistemological question of interaction and complementarity
(integration) between money and goods is ignored in the marginal substitution theory.
Money now is treated as an asset worthy of acquisition as a substitute for goods.
Determination of the marginal rate of substitution and of marginal utility of
money in such neoclassical utility functions thereby implies the existence of a price for
money relative to prices of its substitutes, goods. This very implication, without which
the resource allocation problem using money cannot be meaningful in the neoclassical
economic framework, brings about the ineluctable need for a price of money, which is the
rate of interest. It also ineluctably assumes that such a preference remains embedded in
human behavior, and as such, within institutional behavior at large. Indeed, neoclassicism
(beyond being simply restricted to economics) manifests the hegemony of equalization of
technological change and technology transfers. These carry with them the concomitant
utilitarian values and specific kinds of institutions across trading nations that create the
harmonization of technology according to the neoclassical economic theory of factor
price equalization.

While we increasingly watch the above vases to be the evolving pattern of

structural change in todays capitalist globalization, the following question remains: Even

in the specter of global capitalism with managerial finance, why is a large part of
humanity being marginalized to poverty, financial bankruptcy, uncertainty and
unbalanced economic growth? Why is it that the last two hundred and fifty years of
teaching and practicing neoclassical economics in classrooms and bringing it up on the
drawing boards of the national and global institutions, have not reduced the cost of
technology, the uncertainties and the social costs? These questions enter utilitarian
analysis and render the perception of neoclassical economics with money as an asset in it,
as being totally contrary to the issues of complementarity, coexistence and social balance.
A different conception of money is therefore needed to replace the neoclassical
marginalist relationship between money and goods.
The utility-based conception on money describes a model of money and its
relationship with resource allocation in the framework of steady-state equilibrium.
Consequently, ethical values, laws and policy decisions that simulate the rules affecting
ethical and moral development, cannot remain sensitive in these regimes of optimal
states. Preferences on choices that entered the utilitarian values in the first place, are seen
as optimal, unchanging, and exogenous. An external hegemonic rule has, as if,
automatically regulates human preferences toward accepting the externally determined
datum of certain given values. They are based on neoclassical substitution, optimality and
equilibrium, each reinforcing the other ones. Shackle calls this human unrealism as the
impossibility of describing creative novelty in models of the neoclassical genre
(Shackle, 1971).
Novelty involves the study of process as opposed to optimality. The abandonment
of process in the relationship between money and resource allocation in a neoclassical
economic framework annuls the relevance of continuous monitoring, policing, guidance
and discourse in the system. It thus becomes unacceptable to the world of human and
institutional conditions which are essentially embedded in discourse, novelty and change.
Q-theory of money-economy models and Islamic perspectives
Tobin-Brainard q-theory is an extension of the utility analysis of neoclassical
consumer behaviour in the area of holding of money without a debt instrument. Such a
retirement of the debt instrument can be attained through a balanced budget and equity
participation, none of which imply absence of interest rate in asset valuation.
Q-theory of money is also a re-formulation of its older version called liquidity
preference theory of money (Tobin, 1958). In both of these cases we find that the
discount factor for capitalizing an intertemporal allocation of money in resources is the
central issue.
Note then the following brief formulation: We contend that the problem with qtheory of money in shariah arises from the notion of discounting present in q-theory
(and in general with the entire idea of intertemporal discounting in resource allocation) .
This is an old debate among Islamic economists (Zarqa, 1983). To bring out the bone of
contention against acceptance of q-theory and the discounting methodology, let us first

innocently denote the discount rate by 'r' (and not with 'i' = interest rate) as our assumed
mudarabah-musharakah based rate of return or a weighted average of profit-sharing
rates. What does such a methodology mean in the Islamic concept of resource allocation?
Discounting is a dynamic version of marginal rate of substitution between saving
and consumption. An Islamic economist may argue that the saving can be in profitsharing outlets. This may be true. But the fact remains unchanged. The transfer of
resources intertemporally means that the money capital has been held up today in a
withdrawal called savings in macroeconomics. Hence this amount could not have entered
the cycle of spending. Spending on the other hand, brings about immediate financial
rewards in the form of personal and corporate tax-reductions, economic growth,
increased incomes through employment and inter-corporate profitability, reduction in
government deficits and the consequential price stability with higher real values of
earnings. Each of these social returns enhances socio-economic security at the current
time.
Now why would a person, business, institution and government hope to wait for
an economic return until a deferred moment in time? The argument can be made that
some returns from ventures appear after a gestation period, whereas the social benefits
appear continuously from the moment spending is made. On the deferred component of
economic returns from investment, the nature and meaning of the rate of return is
important to understand. Is this a guaranteed rate or a probabilistically expected rate in
the future? Shariah rejects accepting a fixed rate for asset valuation, whereas the
probabilistic nature of the rate makes it a gamble in the future. In the latter case, shariah
prohibits undue and indeterminate risk to shareholders.
Probabilistic rates defy measurement due to the appearance of contingencies.
What economists have done in such a case is to assume given probability distributions for
the rates and returns. Such is the case with the risk-aversion theory and the adaptive
Markovian models of random variables that Islamic economists have accepted as
methods while being oblivious of the Islamic questions underlying resource allocation
involving discounting (Choudhury, 1992b). Indeed, Imam Ghazzali held the view that
even the economic laws of demand and supply do not describe the real movements of
prices, which he linked with acts of Allah. In probabilistic rates too we find the same
impossibility of their precise measurement in the future (Islahi, 1995).
Let us go on in the arguments. Money cannot exist in the future if transactions are
not well determined then. In this case only probabilistic rates are assumed to exist over
time. This leads to economic speculation. Thereby, money cannot be held intertemporally
in the absence of known rates in the future. Thus in the end, our innocent looking 'r' has
become nothing different than the rate i, a price for waiting due to financial speculation
on future returns. Such a rate can be nothing other than the rates of interest (riba).
The verses of the Quran that support our arguments here are many (Quran
26:183, 55:7-9, 104:2-3, 2:261, 18:19). In so many ways the Quran has unequivocally
exhorted the believers to spend their resources in the way of Allah; that money and

possessions not become a circuit of wealth among the rich; that the absence of circulation
of money reduces its real worth.
The following saying of prophet Muhammad (hadith) speaks eloquently on the
meaning of valuation that must be associated with currently transacted things against
those that are intertemporally distributed:
Exchange of gold for gold is riba unless it is done on the spot in equal quantities;
exchange of silver for silver is riba unless it is done on the spot and in equal
quantities; exchange of wheat with wheat is riba unless it is done on the spot in
equal quantities; exchange of dates with dates is riba unless it done on the spot in
equal quantities; exchange of salt with salt is riba unless it is done on the spot in
equal quantities.
As in the time-value of money intertemporally, we would be trading current
money for money at each point of time in the future. That would be riba. In other cases,
such as for the real estate mortgage (businesses, hence basic needs = salt, dates etc. in the
above saying), we would be trading money today for the money value of the physical
asset in the future. In all such cases money must be transacted through real economic
activities, except in the case of a barter economy (counter trade). Intertemporal
transaction of money for money inevitably appears. This is a riba rule of transactions.
Once again therefore, the innocently looking 'r' as a discount rate of the neoclassical
economic genre and the q-theory alike is nothing but the abominable 'i' -- the rate of
interest.
I have not gone into further details here to discuss the analytical problems
associated with discount pricing and with the conceptions of optimality and marginal
substitution underlying all these when studied in the light of contrasting views. The
contrasting views are of complementarity, diversity and knowledge-induced evolutionary
discourses that are linked with the endogenous preference formation of the Islamic order.
But the keen reader may sense this from my earlier criticism of the problem of exogenous
preferences, optimality and marginal substitution in neoclassical economic theory. All
these are rejected in the context of the essential epistemology of universal
complementarity, interconnectedness, discourse and knowledge-centered evolution
presented in the Quran (13:3-4, 14:24-27, 42:49-53, 43:12, 29:19).
These attributes now bear upon the nature of money in Islam. They render all
variables and relations in Islam to be of the endogenous type. The study of such
interconnected an epiphenomenon in the Islamic economic and social universe is what I
term as the Islamic political economy as opposed to Islamic economics. The latter is a
detached way of looking at economic relations among neoclassical economic goods and
money as substitutes. This neoclassical economic principle of marginal substitution
between goods and money (hence between goods and alternatives) makes the study of
ethics and morality, policy and institutions, technology and knowledge benign to the
presence of process underlying preferences that otherwise remain exogenous to ethics
and learning in their substituted states of competition, independence and optimality.

Returning now to q-theory, we find that there is no way in it of explaining the

interrelationships between money and real economic activities by replacing the
discounting method. Hence interest rate and future speculative transactions remain
endemic in such a method of asset valuation. Furthermore, the neutrality of ethics due to
exogenous preferences together with the marginalist independence among variables and
relations in the neoclassical economic trade-off render the q-theory and all similar
approaches towards explaining the relationships between money and real economic
activities untenable to Islamic ways of understanding the endogenously ethical moneyeconomy linkages.

Keynesian treatment of money and economy in Islamic economics: predicaments

In my opinion much has gone wrong with Islamic economics through writings
that adapted one or the other forms of Keynesian expressions involving money. Such
problems can be seen to arise from all ends money demand and supply, the valuation
of assets and asset pricing and the Keynesian general equilibrium model.
In the Islamic economic literature the rate of profit is found to be mechanistically
introduced in the demand and supply functions without incorporating in these functions
several important factors as follows: What are the behavioural attributes (preferences) of
those who supply money (central banks, commercial banks and high fiat pseudo money)
and those who hold money (households, businesses and governments). In Islamic society
such preference behaviour is generated through Islamic values. In the field of money,
such preference behaviour is applied to the conception and purpose of holding money and
institutional rules towards money and social well-being. Such a web of relations between
money and socio-economic activities, that enter the social well-being function as
complementary ones is realized by an interactive process involving the agencies
mentioned above. Such interactive processes are based on shariah rules that bring about
issues of ethical values, money and real economic activities to bear upon a consensual
development of the rules and policies (ahkam). These ahkam as-shariah are temporally
discoursed, and thereby reinforced, revised and improved. This is the nature of
institutional decision-making and learning process that mark the interactive (ijtihadi),
integrative (ijma) and evolutionary (khalq-in-jadid) processes relating to money, Islamic
preference formation and their combined functional relationship with real economic
activities. Because of the evolution of preferences in such a knowledge-induced process
of interaction, integration and creative evolution (IIE-world view), such preferences are
sensitized by the continuous formation of knowledge in such an order. They are therefore
termed as endogenous preferences.
Endogenous preference formation in Islam is caused by various kinds of shariahbased financial instruments. Among these are security of returns, fairness of contracts and
distribution, appropriate venues of spending and participatory enterprises that arise with
the elimination of interest-based financing, frivolous and speculative ventures. Along
with these, several other socio-economic prerogatives must also be taken up. Among
them importantly are, risk-management by appropriate product and risk diversification
through increasingly participatory co-operative joint ventures.
The profit-sharing ratios to be fair and empowering to both the asset-holders and
the initially asset-less at the grassroots must be re-contracted as wealth and resources
increase in the hands of the once asset-less. The participants in co-operative joint
ventures must be made aware of the stability and security to be gained amidst dynamic
basic needs regimes of change. This is a process in knowledge formation through
discourse and project identification with tradability of both goods and services (skills,
appropriate technology) among the participants.

Consequently, the problem of economic stability cannot be an automatic

assumption in the models of money taken up in the Keynesian framework in Islamic
economics. The problem of stability requires the study of linkages among socioeconomic variables, their relations and agents. This is bound to be a study in the
framework of knowledge forming processes as explained by the IIE-methodology.
Thereby, the demand and supply of money are determined by endogenous preferences in
Islamic political economy. Likewise, through the endogenous nature of money demand
and supply we can study the problems of product and risk diversification that are required
to engender security, fairness and enhanced participation in the economy-wide sense.
The idea of productive mobilization of resources in the Keynesian spendingincome model is also a misnomer for use in Islamic economics. For example, the notion
of full-employment output and resource mobilization in Keynesian general equilibrium
model is fraught with many problems of instability and impossibility of attaining fullemployment equilibrium. For instance, application of rational expectations hypothesis
applied along the Keynesian aggregate supply curve shows that the general equilibrium
point at the full-employment level is both an elusive and a highly charged point caused by
expected price increase.
Therefore, the money demand and supply functions that determine the monetary
sector equilibrium no matter in which system, Islamic or Keynesian, must respectively
include the social and economic forces that underlie the general equilibrium point
determined by the aggregate demand and supply relations. The position of the aggregate
demand curve will explain how a given supply of money is held, i.e. in liquidity or in
assets (Hall & Taylor, 1986)?
Question of saving in Keynesian and Islamic economics
The question of saving against spending appears as a serious debility of the
Islamic models of Keynesian genre. Keynes himself did not encourage savings. He
viewed it as a withdrawal from the level of economic activity. He held the view that fullemployment equilibrium could be established only by fully mobilizing savings into all
forms of `productive spending. Yet the property of the Keynesian money demand
function does not speak the same truth. The unproductive nature of spending re-enters the
money demand function with the appearance of interest rates in the precautionary and
speculative demand functions. In the latter case it causes mobilization of resources into
speculative assets. Islamic economists seem to have forgotten this fact. Consequently,
financial instruments such as bonds and derivatives have become popular among Islamic
financial institutions, which have been put in a race to compete for portfolio savings. See
for example the derivative issues of Faisal Finance in Switzerland. Based on bondtransactions, open market operations as monetary policies have been legitimated in
Islamic economics (Choudhry & Mirakhor 1997). This is contrary to shariah in view of
the nature of interest-based discounting that is inherent in bond financing as the way of
holding money.

The Quran never for once has emphasized saving against spending in the good
cause. One can read the profuse number of verses in the Chapter on Heifer (Bakarah) on
this matter. The lesson of spending is that an Islamic economy must be formed and
progressed on the basis of possibilities generated by product and risk diversification and
by extensive inter-sectoral and inter-agent participation. Socio-economic development
would then mean the attainment of socio-economic sustainability realized by dynamic
basic needs regimes of change. This is how growth menus, employment, technology,
markets and institutions will all be carried forward in tandem with each other. Here the
causal interrelationship between spending and real sectoral activities, as against saving, is
determined by treating money in circulation. When the contrary happens then money
becomes a saving category (M2). With this the rate of interest enters as a return on
savings. Withdrawal increases and resource mobilization is deterred.
In the end therefore, a Keynesian treatment of money in Islamic economics is
neither rich nor explanatory of the essential meaning revolving around the Quranic
worldview of paired complementarity, inter-linkages, discourse and knowledge
formation, and mobilization of resources for realizing social well-being. Issues relating to
bond financing, cost of capital, valuation and asset pricing, the resulting effects of these
on the Islamic ideas of financing and resource mobilization have all remained unhealthy
perspectives (Mirakhor 1996, Kahf 1997, Khan 1996, 1991). They could not contribute
an appropriate methodology to the study of money in Islam.
Endogenous money in Islam
Now after this long discussion on the state of the art respecting money and real
sectoral activities in the economy-wide sense we come to the alternative. The rejection of
the above-mentioned approaches to money and Islamic finance was due to their silence
on the substantively causal interrelationships between money and real economic
(sectoral) activities. In this regard, the endogeneity of variables, their relations and the
same for policies (decision-making), institutions and technologies, have been missed out.
Yet these are necessary for inducing the interactive, integrative and dynamically
evolutionary consensual processes of knowledge formation, within which the causal
interrelationships between money and real sectoral activities are to be studied.
Endogenous preferences, financial and social contracts, participation and
possibilities would then be formed, changed and evolved under a permanent state of
'novelty' that the principles of universal complementarity and diversity bestow within the
framework of process orientation of systemic unity. This is how the quintessence of the
oneness of God (tawhid) is explained in direct reference to the Quran in the worldsystem (alamin), which the Quran characterizes as being filled with His Signs (ayaths).
From the epistemological premise of tawhidi unity arises the unification of knowledge as
the process of complementing the diversity of ayaths by the discoursed capacity of
human reflection upon them (Qur'an, 41:53, 59:24). The principles of universal
complementarity and diversity of possibilities now arise as the governing characteristics
of the Islamic world-system. They completely annul the marginalist hypothesis of
mainstream economics.

On the matter of money in Islam the same causal interrelationship between money
and real sectoral activities is to be explained in view of the social well-being function that
simulates interrelationships in the knowledge-induced framework of the complementing
entities (Choudhury 1998d). Money is thereby not an exogenous factor in economic
activities. Likewise, the real sectoral activities are not independent of money.
A simple explanation relating to price, output, quantity of money and preferences
can be made here. Households have preferences for holding money first for purchasing
dynamic forms of basic needs and comforts. These are Imam Shatibis refinements
(dhururiyath, hajiyyath, tahsiniyyath). Secondly, money is used for earning stable and
secured yields from spending it in the good things of life. Examples here are of profits
and returns from Islamically productive investments; in government financing to enable
the formation and simulation of knowledge-flows among participants, that in turn can
provide essential services, such as, monetary control, security, and defense. Central banks
are induced to control currency circulation as endogenous money and to monitor relevant
policy and departments conducive of this realization. We note that in each of these
agencies the role of a unifying process of knowledge formation is essential. Such is the
interactive, integrative and dynamically evolutionary process of knowledge induction
relating to socio-economic variables and their interrelations. The resulting interactive
preferences then determine the rules and inferences from shari'ah (ahkam as-shariah).
They thereby, link the socio-economic variables with money in the light of the
knowledge-values.
With the continuous introduction of knowledge-flows, a quantity of money as
currency enters the economy in response to the categories of activities as mentioned
above. In turn, as this volume of currency mobilizes resources and increases participation
and linkages in the economy, the productive strength of money is enhanced in turn. This
kind of a causal interrelationship between money and real sectoral activities alters the
picture presented by the controversial M-C-M cycle regarding which both the classical
economists and Marx wrote (Heilbroner, 1985). In the Islamic cycle of causal
interrelationship it is the prevalence of tawhidi episteme that causes unifying knowledgeflows to arise within the complementarity framework of these causal interrelationships.
The guidance to realize these complementary rules from the essence of unity in Islamic
world-system is provided by the way of shariah instruments linking money with real
sectoral values. Hence, by the central presence of knowledge at every new emanation of
causal interrelationships the IIE-worldview overcomes the problem of random circularity
as reflected in Marx's M-C-M cycle (Carchedi, 1991).

With the introduction of endogenous money in Islam, the meaning of demand and
supply of money disappears. That is because neither central banks nor financial
intermediaries can create money exogenously. Exogenous money exists in the form of
promissory notes created by commercial banks with statutory reserves. In the endogenous
monetary system a quantity of money enters economic activity in response to the
financing of real sectoral activities. Money flow thereafter changes in volumes through

recursive interrelationships with the level of economic activity. Now as economic activity
increases, an extra quantity of money is released. Subsequently, this increased quantity of
money enhances more of the activities, and the banks respond. The nature of loan
transactions by commercial bank is determined by discourse among the clients, the bank
and the monetary authorities on the appropriateness of the activities for financing. Such a
discourse rather than being cumbersome, can be regulated by means of manuals
developed through the experience of discourse among agents. They are the result of
evolving perspectives on ahkam as-shariah governing the endogenous causal
interrelationships between money and real sectoral activities with the social well-being in
mind.

Now the resulting money function, M, can be expressed as,

M = M(, x(),P())[Pr],

(5.1)

where, denotes the vector of knowledge-values. These are ordinal assignment in

response to the effectiveness of the IIE-process through an evaluation of the elements of
the vector-valued x() in the perspectives of the application and benefits of ahkam asshariah in the socio-economic order. In this way, x() denotes the knowledge-induced
vector of socio-economic variables influenced by the -values. P() denotes the
knowledge-induced policy variables influenced by the -values. Pr denotes the
resulting interactive knowledge-forming preference formed in the IIE-process of
discourse and leading to consensus (integration) (Choudhury, 1992c).
There is a difference now between the above form of money function and the
equation of exchange in the quantity theory of money. In endogenous money in Islam it is
the primacy of prices that determines the quantity of money and not vice-versa, as
otherwise is the case with the quantity theory of money. It is also the indeterminacy
between the money flow and price level that leaves the quantity theory always
questionable and the relationship unstable in an environment of inflation (Laidler, 1989).
Next we examine how the vector of prices p() in terms of the vector of output,
x(), is related to M, keeping in mind the framework of the IIE-world view on which
these causal interrelationships are derived? The primacy of -values in the IIE-process of
discourse monitors the target of near equality between the rate of growth of output and
money. This would cause inflationary disturbances to be controlled accordingly. Next, the
concept of stability between money, output and prices being that of maintaining
sustainability of the relationship between the rates of change of these variables, the
relationship, gM() = gX(), will be monitored within the IIE-process of knowledge
formation. Here let X() denote an interactive aggregation of the elements of x()
(Klein, 1946). Likewise, p() will denote the corresponding interactive aggregation of
prices. Such geometric forms of aggregation are required due to the extensive
complementarity and diversity of possibilities in the Islamic domain. This determines the
necessary and sufficient conditions for the endogeneity in the causal interrelationships
between money and real sectoral activities. Now since the endogenous process implies
the epistemological background of tawhidi unity and the derived unification of
knowledge signifies the derivation of shariah rules ahkam as-shariah, therefore we can
write, {} (tawhidi Complete Knowledge) (Choudhury, 1995).
From the above-mentioned money function we now derive the causal
interrelationships between money and real sectoral activities that recursively feed into the
objective simulative criterion of the social well-being function, W(.), over {}-values. For
simplicity, we will reduce knowledge-flow to a unique consensual value, , governing all

variables during a range of interaction. We will also identify interaction with knowledge
formation processes, and thus proxy [Pr] by the same uniquely consensual -value. We
now write,
M =
(5.2)

M(, x(),P()),

as the money function in the complementary knowledge-induced variables.

The objective simulative criterion of the social well-being function is given by,
Simulate{} W(M, x, P)[],

(5.3)

the simulation being over rounds of the IIE-processes of discourse leading to

consensus and further evolution of the same.
The recursive relations are,
M= f1(M, x, P; W)[]

(5.4)

Z = fi(yi; W)[],

(5.5)

where, Z denotes the variables, (M, x, P)[] taken alternatively in circular

sequence. yi thus denotes the tuplet out of the triplet shown, by supressing the
dependent variable each time. In any given cycle of recursion, a lagged value of
W is given.
We now have the following directions of causal interrelationships:
with , f((x, P)[]) M(x,P)[] W(M, x, P)[] [New ] evolutionary
processes
(5.6)
tawhidi episteme ------ One IIE-process -----emergence of a subsequent IIE-process, etc.
tawhidi episteme ----ayaths in alamin (world-systems)------- culminating to .
Unity = unification of knowledge: world-system (money-economy)culminating to
.
Money as so formed endogenously and affecting all variables and the social wellbeing through the endogenous process of knowledge simulation is the endogenous money
in Islam. Along with it the socio-economic variables and the policy variables become

endogenous as well. For such endogenous transformations to occur the role of markets
becomes very important. The role of government (state) then reduces to simply guiding
the formation of knowledge and directing choices to the shariah possibilities. The state
becomes a participant with the rest of the agents while it maintains control over limited
principal functions. The derivation of causal interrelationships between money and goods
in the Islamic political economy being different from that of the relations of the quantity
theory of money, the theory of endogenous money in Islam is consequently also different
from the mistaken caption of endogenous plastic money in the present days consumerist
society (Desai, 1989).

Policy issues with endogenous money in Islam

In the system of endogenous money in Islam, it is necessary to convert the
monetary system to a 100 per cent reserve requirement. At first this appears to be no easy
matter in the midst of todays entrenchment of the monetary system based on promissory
notes found in the capitalist penetration of capital markets and macroeconomic policing.
Yet as we are today thinking on post-modernity of the twenty-first century, wherein new
vistas of socio-scientific inquiries are opening up, such new and bold challenges toward
ummatic transformation must not be considered impossible. Below we provide some
policy issues that could help in the transformation of the monetary system in the Muslim
World into a well-coordinated financial order with endogenous money in Islam.
Building up the 100 per cent reserve requirement monetary system
Since the banking authority in endogenous monetary system would simply
provide currency to commercial banks according to the demand for real sectoral spending
in goods and services, investments and social security, therefore, a one-period lagged
volume of bullion requirement is to be maintained. This will back up such a demand. But
the Central Bank will keep an additional amount of currency in reserve without supplying
it to the economy. The amount of currency to be provided to financial intermediaries
would be determined through discourse between the commercial banks, the Central Bank
and the private sector representatives. The latter would come from consumer guilds,
investors, corporations, financial development planners etc. In this way, the volume of
currency to be created is brought in co-ordination with economic prospects. Thereby,
market friendly policy control on money, output and prices is maintained. The result is
improvement in the Islamic social well-being. This happens as extensively
complementary relations now generate participation, linkages, product and risk
diversification. From these conditions economic growth, price stability and socioeconomic development are attained simultaneously -- not in a trade-off.
Within the present conventional banking system, the above kind of discoursed
creation of money could be possible. National development plans of Muslim countries
would then incorporate in them a distinct and focused program for alleviating poverty
and promoting microenterprises at the grassroots (Akhtar, 1997). This kind of focus is not
unreasonable, for today it is being viewed favourably by most governments.
Consequently, a separate balance sheet and statutory requirement would be maintained at
the Central Bank for such micro-monetary entries. Statutory reserve requirement would
be fulfilled on a 100 per cent reserve basis, as Islamic financial intermediaries would be
serving specific target groups and purposes at the grassroots. Any expenses incurred in
holding such a 100 per cent differentiated reserves with the Central Bank would be
imputed in the service charges of the Islamic financial intermediaries.

Micro-monetary issues for development financing with grassroots focus

Most accruals to the 100 per cent reserves will arise from the financial returns
generated in specifically integrated markets. These markets would transact on the basis of
Islamic financial instruments, goals and outlets. Here the principle of universal
complementarity and the consequential product and risk diversification suggest that
microenterprises, Islamic financial intermediaries, the usual private sector and
governments must all broaden out their joint ventures on the Islamic front. Indeed,
microenterprises can flourish during their early stages of development only by cautiously
growing within their own specific kinds of markets for goods, services and financial
capital. The same kind of extension of Islamic participatory businesses would likewise
apply to the global scene through national networks.
Market friendly policies turn out to be endogenous. They require a minimum of
institutional policing, as the IIE-process of knowledge formation and its socio-economic
induction progressively generates knowledge and mobilizes preferences toward
Islamizing the economy. For this to happen, foreign trade and trade financing should be
considered as important venues of joint ventures by Islamic financial intermediaries
towards developing microenterprises and sectoral linkages. In the Muslim world today
with its wide resource diversity and abundance, the principle of complementarity would
work in increasing trade on specific goods and services. The stability of money in the 100
per cent reserve requirement system, the stability gained by risk diversification, the
progressive knowledge induction in making agents aware of the benefits from social
well-being enhancement, would all result in an intensification of trade within the Muslim
World.
Now with a resulting short supply of traded goods, as they will get maximally
used up within the Muslim World, a residual excess demand in the outside world will
appear. This will result in an improvement in terms of trade. Export revenues will
increase for the Muslim World. The resulting export revenues instead of being directed in
financing external debt today will be directed towards attaining social well-being. In this
transformation process the attainment of real economic growth with distribution and
stability appear as complementary factors. The socio-economic benefits would thus be
distributive, not skewed. These kinds of ethical transformation with strong material
benefits to be gained therefrom, are derived by moral suasion on accepting a 100 per cent
reserve requirement system, even though initially, the reserve will appear as a
differentiated monetary reserve specifically maintained at the Central Bank.
Importance of price stability in the 100 per cent reserve requirement monetary
system
Price stability that is to be gained from 100 per cent reserve requirement is an
important issue to study. The choice of a standard numeraire would be primal. Since
money itself cannot serve as a numeraire in such a system, the alternative basket could be

a combination of gold and silver. The numeraire can also be denoted by the value of a
basket of core basic needs (Choudhury, 1992a). There is averaging and indexing required
in these kinds of numeraire selection. Indeed, choices of such basic needs were practiced
by the Prophet Muhammad. The same practice was carried on for many years afterwards,
until the Mamluks devalued the Dinar by replacing it with copper fulus. Price instability,
indebtedness and fundamental disequilibrium in the external sector then appeared
(Allouche, 1994). The same predicament happened to the Turkish Lira when the British
Government of the time monetized the Ottoman external debts with paper money. Today
such a monetization of debt is continuing on in terms of the appreciating U.S. dollar
against other currencies. This is causing massive currency devaluation on a global scale.
The stability of 100 per cent reserve requirement monetary system is further
enhanced by maintaining the growth of the volume of currency in line with the growth of
demand for real goods and services. The aggregate demand is now derived by aggregate
output in terms of its non-linear aggregation, as mentioned earlier. With such a balance,
total productivity can be preserved and inflation can be removed. Likewise, indebtedness
can be annulled and the average propensity to spend can be increased both domestically
and by foreign investors. Foreign investors would have to strictly comply with the
shariah requirements of non-speculative investment and transact in specifically
integrated markets outlets.
Monetary vouchers for holding endogenous money in 100 per cent reserve
requirement system
The route to monetary stability starts from the time money is held in the form of
currency to the time it is spent in shariah approved outlets. Any delay in this respect
becomes a leakage, which is denoted by savings. A bank client can be given a voucher
denominating his bank deposits. The deposits at any time are instantly converted into 100
per cent reserves with the central bank. Only a marginal amount is kept as cash-in-vault
to meet the instant liquidity demand. The client can fractionally liquidate his voucher just
as a check and claim his deposits proportionately on that basis. There will be an
accompanying return that would have been generated in the pool of invested fund in
which that deposit was initially absorbed as soon as it was converted into 100 per cent
reserve and allocated into approved spending outlets. The client could re-deposit the
unused money for the equivalent residual value of voucher.
The effect of the voucher is like that of a treasury bill. Now the Central Bank
instead of creating money supply sells bills that commercial banks hold. This sterilizes an
equivalent amount of money creation that could have been generated by an increase in
foreign reserves (Brown & Hogendorn, 1994). The difference between endogenous
money vouchers and treasury bills is this. Since the specifically integrated markets for
goods and services that link up with 100 per cent reserves in the Islamic framework tend
to Islamize the political economy, shariah outlets must be well-determined. The very
fact that this kind of spending establishes stability and socio-economic returns is instilled
as an incentive through moral suasion using the IIE- knowledge forming the process
explained earlier.

Liquidating outstanding foreign debt

Next we turn to the case of liquidating outstanding external loans. How are these
to be paid out as long as the interest-bearing payments contracts remain with foreign
creditors? The answer is that an additional supply of currency to settle debts in the short
run must be serviced, while alternative instruments such as debt-equity swapping and
buy-back options can be adopted with foreign creditors to settle residual outstanding debt
(Krugman, 1989). In course of time however, increasing Islamization of the Muslim
World must focus upon participatory joint ventures in co-operation among themselves.
Similar ones can be extended to other participants provided the shariah conditions of
such ventures are preserved in the light of the causal interrelationships between money
and real sectoral activities.
The above kinds of Islamic transition promoted around trade liberalization,
monetary co-ordination and integrated markets in the Muslim World is a market friendly
approach toward monitoring a direct linkage between money and real economic
activities. This kind of transformation establishes cause and effect between a 100 per cent
reserve requirement with high powered money, output, prices and all those socioeconomic variables that simulate the social well-being function. Money now finally
becomes equivalent to a volume of currency created on demand and fractionally held
according to the liquidating nature of vouchers that back up spending.
One can note that in all of the cases discussed above there is a sharp distinction
between Keynesian and neoclassical policies and the ones mentioned for endogenous
money in Islam. The policies on creating targeted volumes of currency in accordance
with spending demand, moral suasion and specifically targeted market outlets with the
grassroots focus in development planning within which Islamic financial intermediaries
are required to operate, implies the following: Money is never held either as a marginal
substitutes against goods or according to any of the motives enunciated by Keynes and
Tobin. This is true even if we were to reduce the quantity of money to meet simply
transaction demand. The difference lies in the causal relationship first, between money
and prices in view of the goods transacted prior to money being created; secondly,
between the two when money simultaneously provides a valuation to the market
exchange.
There is no causality in Islamic political economy such as, money determining the
level of prices. That is because even as real sectoral activities determine the demand for
currencies as money and this determines the level of social well-being, the next round of
monetary expansion is determined by the introduction of a new level of knowledge
formation in the IIE-system. This dynamics once again sets the desired relationship that
should exist between output, prices and fresh quantities of money. Money is thus simply a
contravention for valuation without having any intrinsic value of its own. It reflects the
value stored into it by market transactions.

Policy conclusion
In conclusion, we note that the abolition of interest-based transactions by means
of profit-sharing ventures of different kinds will require an extensively participatory
political economy. In such a venue, financial capital and integrated markets for goods and
services must become directly interlinked. Only non-speculative real sectoral activities
would be accepted. Through such a web of participatory worldview the whole range of
productive activities is to be simultaneously realized. Thereby, stability of prices, storedvalue of money and yields can be secured. Participation brings with it product and risk
diversification.
The Islamic Development bank has been promoting trade and development cooperation in its membership (IDB, 1997). The programs here take the form of finance
ministers co-ordination meetings on trade related issues; co-operation with Islamic
banks; investment, insurance and export credit schemes; contributing to the activities of
COMCEC (OIC standing committee on economic and commercial co-operation);
regional economic co-ordination efforts. Yet at the end we note that IDB still has much
more active role to play in contributing to the development planning of member countries
in bringing them into mutual harmonization and thus realize economic integration. The
IDB and her member states should now think anew in the area of monetary, financial and
institutional transformation along the lines that we have prescribed in this chapter. The
impediment to change has come about due to the absence of participatory will. The lack
of participation among all segments of society, particularly with the grassroots and the
Muslim countries subservience to the Bretton Woods economic policies and programs
have caused unbalanced development and trade diversion rather than trade creation
within the Islamic bloc.
In order to realize such an economy-wide and ummah-wide participatory political
economy, money becomes an important instrument of valuation of real transactions that
occur. Such endogenous money can simply have a store of value that it reflects on the
basis of the exchange value of the goods and services according to shariah
permissibility. But here, shariah promotes market friendly goods and services under its
ethical and moral norms. It dissuades excessive institutional policing. Thereby,
knowledge formation becomes the central force behind a participatory transformation of
the future ummah in the framework of endogenous socio-economic reality including
money, markets, economy, society, policy variables, institutions and appropriate
technologies.
The instrument of moral suasion in bringing together money with the direct
valuation of the real economic activities according to the standards of shariah forms a
critical element of the knowledge formation process in shuratic discursive systems. Such
a shuratic process is signified by the interactive, integrative and evolutionary worldview
(IIE-methodology). Money finds itself as a creative instrument in such an unifying
process and becomes an universally complementary and participatory instrument of

ummatic transformation. Money so understood is called endogenous money in Islam

(Choudhury, 1997). It is the cause and effect of the 100 per cent reserve requirement
monetary system.

The politico-economic planning toward creating such endogenous money in Islam

and its supportive 100 per cent reserve requirement monetary system must become the
priority development financing objective for the future Islamic world. There is both social
well-being to be attained as well as great methodological weight in this. Such a process
toward ummatic transformation is seen to be possible and feasible starting right now with
the existing monetary authorities. In the new era of human development such a monetary
medium can transform the financial and monetary architecture into a global model of
empowerment, stability and social well-being. The Islamic values of well-being rise
above the existing disabling uncertainty and instability of the inequitable world-system of
money, wealth, resources and goods.
The reciprocity of trade between Islamic countries is essential for establishing a
common market and this can happen only through a proper use of Islamic financial
instruments for realizing inter-sectoral linkages among real sectoral activities and
commodity transformation. For this to happen Islamic countries cannot gain from the
existing monetary and financial policies that are steeped in interest rates. Interest rate
backed macroeconomic policies were shown in this chapter to be intrinsically unstable
and to deprive social well-being. It is therefore, high time to think in terms of changing
the entire structure of interrelationships among money, financial instruments, trade and
development in ways that can look forward to a viable participatory economy in the years
ahead.
The combination of sheer time-dependent and normatively qualified estimates of
the trade and development variables between Islamic countries for gaining more
complementarity among themselves seems to run into a rigid bottleneck. This is
particularly true with respect to the monetary policies of these countries (SESRTCIC
1988).
Thus the discount rate monetary policy was actively pursued. This made the
commercial banks to freely transact their excess reserves in any kind of assets that they
considered acceptable to them in view of sheer profitability of operations on the basis of
interest charges. Commercial banks thus gained independence in their portfolio selections
in recent times. The contrary objective of establishing a learning and guidance
relationship between the central bank and the commercial banks with the clientele
presence in the decision-making process, a feature of the Islamic institutional knowledgeinducing process, was non-existent. The role of the policy of moral persuasion in view of
the learning experience of relating a stable quantity of money to real sector activities was
not a prime objective. One therefore finds that a disproportionately greater proportion of
the central bank loans went to the industrial sector as opposed to the agricultural sector.
This was despite the fact that all of the countries studied happen to be agricultural
countries.
Subsequent to such a policy of favouring the development of the industrial sector
disproportionately over the agricultural sector, led to the marginalization of the
agricultural sector in these countries in recent times. The result was also the external

sector disequilibrium caused by the heavy indebtedness of the industrial sector relying on
imports.

In terms of money markets, the financial institutions in Muslim countries

promoted open market transactions, although this is of recent experience. However, the
lack of product, risk and economic diversification in the real sectoral activities did not
give stability to these capital markets. Here either the experience of developing strongly
risk-diversified securitized markets does not exist. Governments play an overly excessive
role in capital markets, thereby causing inefficient allocations by a lack of appropriate
instruments, policies and institutions for the mobilization of private capital (Arif, 1995).
In the external sector, the exchange rate stabilization policy depended upon
maintaining a floating exchange rate despite the central banks intervention to maintain a
fair level of their domestic currencies. Here a lack of well-developed open market
operations, a heavy reliance on foreign direct investments recently characterized by the
flight of capital and high external debt outstanding caused by unbalanced industrializing
policies, could not make currency stabilization by monetary policies effective.
Consequently, high central bank reserve ratios were enacted as monetary policy. This
adversely affected the mobilization of national savings into investments. The alternative
rested upon borrowing abroad, reliance on foreign capital and development financing
from donor agencies. The resulting lower real productivity at home and its rescue by the
use of monetary reserves to stabilize the resulting exchange rate-volatility meant that the
real value of the currencies was not tenable in supporting export demand. Devaluation
was a frequent feature of these economies as a result.
The normative institutional financial undertaking based on endogenous money in
Islam has been shown in this chapter as a viable alternative in establishing a viable level
of real productivity by linking monetary flows endogenously with real sectoral activities.
The equities market, joint ventures and participation both instrumentally as well as
institutionally among the countries in making collective and co-ordinated decisions is the
way out. This is how through appropriate linkages between the real sectoral activities in
trade as the medium, a balanced trade and development regime can be established and
more effective Islamic economic integration thus attained. This is the message imparted
by the real asset-backed money and Islamic financial index introduced in this chapter.

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