ABSTRACT
Conventional finance has become such a common practice that nobody hardly questions its value. Providing an alternative way to finance, like Islamic economics, must be justified. Islamic finance is based on a different philosophy, contracts, and institutional setup. This makes such justification even more necessary. We provide in this chapter our economic rationale for Islamic finance. It starts with a critique of the interest rate as a source of economic inefficiencies and the disadvantages surrounding its use as a policy anchor. Economists have ignored for long the fact that the interest rate has no traceable relationship to economic fundamentals. Contrary to their common understanding, its use as a policy anchor would lead to unpredictable results in the real sector. As an alternative, we offer Islamic finance within an institutional structure that replaces lending-based money with equity-based money. This radical shift is associated with an equity-based money market which is more suited for using open market operations. The financial markets would be radically reformed, including disallowing debt and pure risk trading, which would improve the transmission mechanism between the changes in the rate of monetary expansion and the real sector. As leakages to debt and pure risk trading are no longer possible, monetary policy enjoys full effects on the commodity sector. In addition, the proposed system removes the inequity surrounding the system of fractional reserves and the instabilities. Switching to total reserves together with equity-based money renders a sizable seigniorage to the government that can be used to reduce taxation to improve the infrastructure, boosting the possibilities of economic growth.
