The modern economy is driven by a monetary system where interest rates become an undetachable element of economic trends. Recent cases show that if there is a change in interest rates imposed by a country’s central bank, it has a significant impact on the country’s overall economy. Even other countries’ central banks may have some influential impact on other countries, such as the Federal Reserve of the USA, which influences countries relying on the US Dollar for their economy.
To illustrate, a downturn in economic movement caused by, say Covid-19 pandemic drives the central bank to lower the interest rate. Through this initiative, the economy could rise because credit or financing given by commercial banks will be cheap. Productions could be generated, and public spending would increase. However, a low-interest rate does not encourage people to save money in commercial banks. Because of it, according to some economic thought, maintaining a positive time preference for money, people would spend their money for current consumption instead of saving it.
Is it good for the economy? Producers or merchants will seize the opportunity to increase the price of goods and services because of easy money, normally named as inflation. To control it, a country’s central bank would again play its power to increase interest rates, driving people to save their money in commercial banks. Thus how the interest rate and inflation are interrelated with each other.
Would the interrelation of interest rates and inflation lead to sustainable economic growth? People may lose jobs because of a surge in interest rates. The most recent case was the Federal Reserve of the USA (the central bank) which decided to gradually increase the interest rates within only six months. The cost of funds absorbed by start-ups or growing companies also increases accordingly.
How does this economic phenomenon occur in the modern economy? Does the interrelation of interest rates and inflation resemble the so-called chicken-egg proverb, which one does exist first? This article explores the issue of interrelation from a historical Keynesian economic perspective and how Islamic finance perceives the issue. It will sum up whether it is possible to run the monetary system without an element of interest rate.
Interest Rates and Inflation, which one does exist first?
In fact, it is difficult to trace which one comes first unless the context is apparent. To ease our answer, we may take the context of the history of the Great Depression in the US in around 1930. During the Great Depression, interest rates may have contributed through the gold standard. At the time, the US was still on the gold standard, which meant that the value of the dollar was tied to the value of gold. In order to maintain the gold standard, the Federal Reserve was required to keep interest rates high in order to prevent an outflow of gold from the US. This high interest rate policy made it difficult for businesses to borrow and invest, which contributed to the severity of the depression.
To support a resurgent US economy, Roosevelt as the new US president in 1933, made a controversial new deal. The New Deal employs Keynesian economic theory, whereby governments can and should stimulate the economy. This goal began to be achieved through efforts to control prices, workers’ wages, and production costs. The main focus is on supporting prices and minimum wages and removing the government from the gold standard as the asset backed currency to the fiat money, prohibiting individuals from hoarding precious metals. From this, the Federal Reserve can set lower interest rates, so people and businesses can easily make a credit to stimulate economic activity.
If we look from the issues above, we can assume that maybe interest is the egg, why? Because interest is power to play a country’s economy through the banking system. However, if the interest is not properly controlled, this will cause inflation. In the sense of also being able to control the supply chain properly. Inflation can still occur if you depend on foreign supply, too.
The definition of Inflation itself is a price increase, translated as declining purchasing power over time. The price increase, often expressed as a percentage, means that a currency unit effectively buys less than it did in prior periods. To illustrate inflation, the price of one pizza in 2016 was USD 4, for example, and then in 2023, it increased to USD 9 per pizza. Can you imagine how the price of goods is increasing?
Types of Inflation
Inflation is sometimes classified into three types: demand-pull, cost-push, and built-in inflation. First, demand-pull inflation occurs when an increase in the supply of money and credit stimulates the overall demand for goods and services to increase more rapidly than the economy’s production capacity. It increases demand and leads to price rises. The main causes of demand-pull inflation relate to the money supply, government spending, and foreign economic growth influences.
The second type is cost-push inflation. It results from the increase in prices working through the production process inputs. When money and credit supply additions are channelled into commodity or other asset markets, costs for intermediate goods rise. These developments lead to higher costs for the finished product or service and work their way into rising consumer prices.
The last type of inflation is Built-in inflation. It is related to adaptive expectations or the idea that people expect current inflation rates to continue in the future. As the price of goods and services rises, people may expect a continuous rise in the future at a similar rate.
What is Interest rate and FRB System?
Interest rates are the primary tool a country’s central bank uses to manage inflation. The interest rate is the additional amount with the principal the money lender charges to the borrower. An interest rate also applies to the amount earned from a deposit account at a bank or credit union.
To discuss more, let us know first about the existence of interest rates. Economists have numerous reasons. The most discussed reason interest rates exist inside the economic system is because of the concept of Time Value of Money. In a short term, it can be interpreted as spending now is better than within the future, whereas in the future prices of goods and services might also rise up (inflation). To compensate for this problem, those who have cash need to be compensated for people who use their money by using interest.
This model forms the basis for the operation of the banking system. Consequently, interest rates are an essential element of the banking system. In addition, modern economies use the Fractional Reserve Banking (FRB) system in which a good way to generate money, the central bank is required to hold equal assets to support the entire money supply. How to implement it? The central bank gives one $100 million to commercial banks. Commercial bank A uses this amount to make a $90 million loan while $10 million is deposited at commercial bank B, then makes a $9 million loan while the rest is deposited at commercial bank C, and so on. In this situation $100 million becomes more than $200 million. The exact base is one hundred million US dollars, but the money circulating within the economic system is a lot more than that. This scheme is pushed by interest rates as an incentive for banks to generate profits.
Is that bad? The reason depends on the context. Imagine the banking system nowadays, why can FRB with interest in it exist in the modern economy? Because in most countries, banks are required to keep a certain amount of their customer’s deposits in reserve. Hence, it can maintain economic stability and can prevent bank runs because there is always a risk that withdrawals may exceed their available reserves.
On the other hand, despite having the advantages of FRB and interest rates from the banking system, it also has several weaknesses where the effect of using FRB can cause an economic cycle to occur every ten years approximately. Moreover, money today does not have an intrinsic value.
Meanwhile, an alternative solution to prevent an economic cycle is using asset-backed currency as before the early twentieth century. Because the asset-backed currency, even if there is no intrinsic value, can maintain the currency stability and control the purchasing power.
As for FRB’s existence, financing and funding are very easy today. The weakness of this is that funding is easy, so people can always buy goods and services that are not really needed. For instance, they are buying four smartphones and three cars with financing even though one device and one vehicle are good enough. In addition, we know that more vehicles means more carbon emissions and can cause climate change.
To illustrate, with the ease of financing, there are 10 tissue factories that have been established and funded by financial institutions. Imagine if this funding did not happen, there might be less tissue factories that had just been established.
How Islamic Finance Perceives Interest rates and Inflation?
As it is discussed above, according to some economists, the existence of interest rates in the economy is because of inflation. Throughout history, inflation has been occurring in the economy undeniably. However, interest rates could be considered as a new concept in the economy since the introduction of the banking system. To begin with, Islamic finance appeared to be the mainstream financial system offering an alternative financial system based on debt with interest.
Interest rates are not the only tool to manage inflation. Islamic history has experienced this phenomenon. Although the banking system was not prevalent then, the following quick story will provide some lessons that could be learned.
First, let’s date back to the Mamluk Dynasty in Islamic Empire to know the experience. The Mamluk dynasty ruled in Egypt for a long time, adorning the essential records in Islamic history from 1249-1517 AD. At that moment, Islamic society experienced dealing with inflation from demand-pull (over money supply).
During the Mamluk Dynasty, there was regular instability within the monetary system. During this period, money has intrinsic value. Three types of money were circulating namely dinars (gold), dirhams (silver), and fulus (copper). The circulation of the dinar was minimal, while the circulation of dirhams fluctuated. A large amount of fulus in circulation and the increasing amount of copper compared to dirham currency affect the instability of the monetary system. It sometimes even disappears. Meanwhile, fulus was over-circulated so that it caused low-quality money that would kick out the high-quality money (dinar and dirham).
Is Interest the same as Riba?
Meanwhile, do interest rates represent riba (usury) in Islam? We should know what riba means and the reason for riba’s prohibition (illat riba). Scholars have agreed that riba is forbidden in Islam based on the Quran and the Sunnah. However, they are diverse in whether the interest rate is considered riba, particularly riba al-dayn (usury in debt). There are two primary fiqh schools in this case.
First, some Egyptian Sharia scholars argue that riba does not apply to the modern monetary system in which money circulates within the banking system. The rationale of riba prohibition was a limited reason (illat qashirah) for the golds and silvers when both were used as a medium of exchange and may not be out of these two things. But the issue today is that we no longer use gold and silver as a medium of transaction. Scholars in this position even further maintain that interest rates aim to balance the value of yesterday’s money with today’s. So, it can be assumed that apart from these two things, it is not a matter of riba, even the interest rate.
Second, the majority of Sharia scholars perceive that interest rate is the substance of riba al-dayn. Any increments within a lending transaction are riba. It is not limited to gold and silver as the medium of exchange. Whatever currency represents the medium of exchange, riba applies to it.
This article prefers to follow the majority of scholars in dealing with both scholars’ arguments. Despite the first argument being somewhat valid in its context, it is favourable to escalate our understanding from the fiqh perspective to the maslahah (benefit) perspective. Maslahah is looking at a broader scope. The current banking system dictates that money has no intrinsic value. A monetary system that is based on underlying debt (fractional reserve banking) increases the gap between poor people (unbankable) and those who are rich (bankable). Islamic finance is a global dakwah.
After discussing interest rates & inflation above, we almost know which one is chicken or egg and which one does exist first. However, we still have difficulty determining chicken or egg without looking at the context.
If we look at the facts about the recent bank collapse in the US, maybe interest is the egg. Why? Because interest is power to play a country’s economy through the banking system. However, if the interest is not properly controlled. This will cause inflation. In the sense of also being able to control the supply chain properly. If you still depend on foreign supply too, then inflation can still occur.
As for the Islamic perspective, from the discussion above we can conclude that in response to this, it is better to avoid the interest rate system whenever possible. Because interest rates are riba (usury) ad-dayn. And usury is something that is prohibited in Islam.
However, if we look at history, maybe the best is a monetary system with an asset backed currency, which does not have to be gold but can also be equivalent to gold. That could be a solution in avoiding the interest rate system. That means, there needs to be an underlying asset.
For the rest, find out more about the education of Islamic Economics and Finance by joining iBantu Academy.
Head of iBantu Academic
Abdus Salam Muharam