8 The Concept of Money in

Islam
Two questions have to be asked in relation to money in Islam. First,
in what sense is money used as a store of value and a medium of
exchange? Second, what is the nature of stability of monetary aggregates
in the Islamic economy in order to establish money as a standard to
value assets? In this brief exposition we will simply introduce the salient
concept of money in Islam while answering these questions. Detailed
development of the idea of money in Islamic economy in comparative
perspectives can be found elsewhere.1

EXOGENOUS MONEY IN THE KEYNESIAN AND RATIONAL

EXPECTATIONS SYSTEMS

In received monetary theory, the stock of money is seen to be exogenously

supplied, as in the Keynesian system, or it is targeted to the number
of real transactions in the goods/services market through the money
multiplier expressed as a function of the speed of circulation of the
quantity of money, as in the quantity theory of money.2
In the pure treatment of monetary aggregates as exogenous stocks,
the demand for and supply of money are predominantly determined by
the rate of interest and national income. Furthermore the rate of interest
affects national income in this system. In this demand-supply relationship,
the presence of the interest rate, particularly in the speculative and
precautionary components of money demand, destabilises monetary sector
equilibrium. This is so because the rate of interest is governed by
expectations. Consequently a field of interest-induced randomness surround-
ing the expected equilibrium point perpetually generates an endless
cycle of excess demand and excess supply of money. These excess
demand-supply situations cannot be eliminated by recourse to a cobweb-
type lagged adaptation model or a rational expectations formalisation.
The reason for this is that there is no specific incentive in the speculative
demand component to establish an adaptive cobweb equilibrium when
consumer preferences predominate. Exchange rate randomness further
compounds the uncertainty.

169
M. A. Choudhury, Studies in Islamic Science and Polity
© Masudul Alam Choudhury 1998
170 Studies in Islamic Science and Polity

Likewise, since the anticipated money supply causes an increase in

the price level under rational expectations, real output remains neutral
of the increase in both money supply and price level. Consequently,
stabilisation of interest rate fluctuations is not seen to be a policy focus
in the anticipated money and adaptive price lends under the rational
expectations hypothesis (REH).
Conversely an 'unanticipated' money supply according to REH causes
price increases of the demand-push type. Any excess demand situation
in such a case is arrested in the short run. Inflationary pressures
subsequently die down. The process of monetary equilibrium here is
similar to the Keynesian demand-push phenomenon. Consequently
monetary policy becomes neutral in the attainment of full-employment
level of income. Thus monetary sector equilibrium makes little sense
in attaining full-employment target of output in this case.
The offshoot of the above discussions is that the exogenous supply
in the presence of a speculative and precautionary component of the
demand for money causes unresolving random fields around expected
monetary equilibria. Monetary disequilibrium thus perpetuates in the
presence of interest rate fluctuations. Such a randomness causes the
exchange value of money to be influenced by fluctuations in the rate
of interest, and does not reflect either the properties of store of value
in money or stable valuation of assets. The resulting monetary aggre-
gates thus fail to satisfy the essential conditions of stability, exchange,
valuation and convertibility of the monetary numeraire.1

A SIMPLE FORMALISATION OF RANDOM MONEY, PRICE

AND INTEREST RATE FLUCTUATIONS

A simple formalisation proves the above results, as follows. Let Ms =

MX(Y, i) denote the supply function of money in nominal income, Y
and nominal interest rate, /. Let the demand for money be denoted by
Md, Md — Md](Y) 4- Md2(Y, i) + Md3(i), with, Mdx as transaction
demand, Md2 as precautionary demand and Md3 as speculative demand.
Real income, y, is given by y = YIP, P being the price level, such that
y = YIP = (Y{)IP())exp(gY - gP)'t. In log-linear form this expression
is written as log y = log(K()/P0)exp(gK - gP) • t.
When Y increases at the same rate as money supply, Ms, in order to
establish long-run, full-employment output gP must be proportional to
the growth rate of the money supply. Thereby such movements will
neutralise the effect of Ms or P on >'.