The Financial System and Monetary Policy in an Islamic Economy

The central characteristic of an Islamic financial system is the absolute prohibition of the payment and receipt of interest. Only an uncertain rate of return based on profits is permitted. Thus, an Islamic banking system is essentially an equity based system in which depositors are treated as if they were shareholders of the bank. Several methods that allow banks to act as intermediaries between savers and investors, while at the same time following the guidelines of Islam, have evolved. The most common of these methods are transaction deposits, investment deposits, Mudarabah, and Musarakah. A simple macroeconomic model of an Islamic banking system, similar to the IS-LM model, shows that it is unimportant whether authorities attempt to influence monetary conditions through changing the money supply, or use the flow of Mudarabah financing as an intermediate objective. Both types of money policy measures yield identical effects of financial rate of return. An expansionary moneta