Islamic Monetary System

The distinctive facet of an Islamic financial system is the absolute prohibition of interest (riba) and well functioning zakah system. Islam aims to promote the virtues of ‘Adl and Ihsan among its followers and after providing basic necessities to all the government need minimum state intervention to establish a just social and economic order. However, to ensure social justice and, in the context of prevalent conditions, the state is empowered to take all necessary actions within the framework of Islamic Shari’ah to achieve this objective. The countries that have chosen to bring their economic parallel with the rules prescribed by Islamic law have had to restructure their banking systems to conform to the restriction on interest-based financial transactions.

Islamic banking system is fundamentally an equity-based system in which depositors are treated as if they were shareholders of the bank. Accordingly, depositors are not guaranteed the nominal value, or a predetermined rate of return. To remain consistent with Islamic law, the bank cannot charge interest in its lending operations, but has to use special modes of investment and financing that are also based on the concept of taking up profit and loss mutually.

The conduct of monetary policy in an Islamic economy has also been addressed recently in a number of papers1 .Similar to conventional system Islaic monetary systems seeks to establish monetary stability with economic well being and full employment along with economic growth. In addition, it aims to promote social distributive just by recognizing need for elimination of poverty. There are a number of policy instruments available for controlling domestic liquidity. These include, for example, changes in reserve requirements, overall and selective controls on credit flows, changes in the monetary base through management of currency issue, and moral suasion. Central bank should allow expansion of money supply only to the extent it is justified by a possible contribution to growth in real balances Furthermore, as pointed out by Akram Khan (1982) and Siddiqi (1982), open market operations could still be conducted with securities that do not bear a fixed rate of return. The monetary authorities also have the possibility of directly changing the rates of return on both deposits and loans by altering the ratios in which the banks and the public are expected to share in the profits and losses that are associated with the transactions, i.e., the profit-sharing ratios. Other than their own capital and equity, the main sources of funds for Islamic banks are two forms of deposits - transaction deposits and investment deposits. Murabahah, musharakah leasing etc are Islamic tool of financing investment.

To begin with many seemingly makeshift and second-best policies have been adopted, but this is only to be expected as Islamization of the economy involves a learning process . What Islamic economic system looks like is not like what Islamic banks are right now. Considerably more theoretical analysis and actual experimentation is required to reconcile the rules and codes of economic behavior that have evolved over fourteen hundred years with the functioning of a modern-day economy. Yet Islamic banking has proven that equity based banking is still most viable and best source to prevent handle financial shocks. However, economists still have much to contribute concerning the directions that the Islamization of economies takes.