Concept of Money

ECON 3430 - Islamic Banking and Finance
Topic 3 - Concept of Money 1

Concept of Money
Outline
Functions of Money
Money as a Commodity
Money and Inflation
Time Value of Money
Introduction
A layman understanding of money all currency (notes and coins)
Technically, anything that is accepted as medium of payment for
goods and services is money
In ancient times, people used rocks, leather, salt and shells as money
The Roman Byzantine used gold coins (denarius) and the Persians
used silver coins (drachma) as currency
When the Prophet s.a.w. brought about economic reforms, he
continued the use of the Roman denarius and the Persian drachma,
known among the Arabs as dinar and dirham, respectively
Prominent scholars of the past such as al-Ghazzali, Ibn Taymiyyah,
Ibn Khaldun and al-Maqrizi have asserted that Allah s.w.t. created
two metals, gold and silver, as medium of exchange and measure of
all things
Gold played the role of money throughout Muslim history
Gold continued to be part of the international monetary system until
the breakdown of Bretton Woods in 1971
Today all national currencies are fiat, that is, neither backed by nor
redeemable for gold
Primary Functions of Money
Fundamentally, money has 3 primary functions
1. Medium of exchange
Eliminates the problem of double coincidence of wants
Divisibility of money makes the exchange of different
quantities of items possible and simple
Promotes specialization, enhances trade among people
Addresses the inefficiencies of barter trading
Greater economic efficiency leads to increased productivity,
quantity and quality of goods and services
Standard of living improves
2. Unit of account
Money is used as measure of value
Eliminates the need to quote the barter exchange prices between
every pair of goods and services that exist in the economy
3. Store of value
Preservation of purchasing power
If $X can buy a basket of goods today, $X should be able to buy
that same basket of goods in the future
Ideal Characteristics of Money
For an item to function effectively as money, it should have the
following characteristics:
1. Standardizable its value ascertainable easily
2. Accepted widely has intrinsic value or made acceptable by
decree of law (assigned legal tender status)
3. Divisible can be used for exchange of a range of values
4. Mobile easy to carry around
5. Stable and durable does not deteriorate, perish or erode due to
its own structure and composition
Money as a Commodity
The advent of interest-based lending has introduced a fourth
function of money money as a commodity
The basic idea is that money has an automatic right to earn
more money
It is argued that, just as a merchant can sell his commodity for a
higher price than his cost, he can also sell his money for a higher
price than its face value
Similarly, just as a person can lease his property and can charge
a rent against it, he can also lend his money and can claim
interest on it
Money as a Commodity the Islamic Perspective
Islam rejects the notion that money is a commodity
There are differences between money and commodities
Money has no intrinsic value, it in itself cannot be used for direct
fulfillment of human needs
Commodities can have different qualities while money is
perfectly homogeneous
In a commercial transaction, specific commodities are identified
for exchange whereas money is generic
Imam al-Ghazzalis perspective
The creation of dirhams and dinars (money) is one of the
blessings of Allah
Money serves the critical function of facilitating transactions of
exchange
Money is not an objective in itself
Treating money as a commodity (trading in money) goes against
the original wisdom behind its creation
The prohibition of riba dictates that money should never be treated
as a commodity
Characteristics of Todays Monetary System
Fiat money
Allows central banks to create money
Convertibility of currencies to gold totally abandoned
Given that the costs of printing fiat money is minimal, fiat money
provides a net gain to its issuer in terms of purchasing power
(concept known as seigniorage)
Fractional Reserve System
Allows commercial banks to create money
Used as monetary policy to manage level of money supply
In Malaysia, statutory reserve requirement (SRR) ratio currently
at 4%
Interest-based Lending
Major factor of todays economy
Interest rate used as monetary policy to manage the economy
Trading of money in foreign exchange markets
Daily volume of USD1.2 trillion (50 times the level of world trade)
Most of the transactions are speculative in nature, using
derivative instruments
1. At the beginning there is the Bank and Mr. A, who was cash 1,000
Bank Mr. A
Cash 1000
2. Mr. A deposits his cash into the Bank by opening a checking account. There is no change in money supply. Money
simply changes form from paper currency to a checking account. Paper currency deposited in the Bank (a claim by Mr.
A) is not money.
Cash 1000 Checking a/c 1000
3. Mr. A applies for a loan which is granted by the Bank. Because the SRR is 10%, the Bank is able to lend 9,000.
Money supply has now been increased by 9,000 (total of 10,000). The implicit assumption here is that at least 9,000 of
that 10,000 checking account balance will remain as accounting money, a mere electronic balance within the banking
system, and not converted to paper currency, thus the SRR ratio.
Bank System
Cash 1000 Checking a/c 10000
Loan 9000
Note: This is a simplistic example but serves to illustrate the point.
Money Creation by Commercial Banks
Mr. A Bank
Mr. A
Money Creation in Fractional Reserve Banking
Deposit 10,000 Reserves 1,000
Loan 9,000
Reserves 900
Loan 8,100
Reserves 810
Loan 7,290
Deposit 9,000
Deposit 8,100
These loans represent money creation
because the original deposit of 10,000
remain as money (can be withdrawn on
demand)
Repercussions of Treating Money as a Commodity
Economic plight has been attributed to the fact that today money is
not restricted to its primary function as medium of exchange
The Great Depression of 1930s, 1997-98 Asian Financial Crisis
Financial transactions not linked to the real economy
Riba is prohibited because it prevents people from undertaking
real economic activities. This is because when a person having
money is allowed to earn more money on the basis of interest,
either in spot or in deferred transactions, it becomes easy for him
to earn without bothering himself to take pains in real economic
activities. This leads to hampering the real interests of the
humanity, because the interests of the humanity cannot be
safeguarded without real trade skills, industry and construction.
[Imam Al-Ghazzali]
Repercussions of Treating Money as a Commodity (2)
Why someone in Singapore is able to gamble on the Tokyo
Stock Exchange and bring about the collapse of a bank in
London? Why do young people trading in derivatives in
London get annual bonuses larger than the whole annual budget
of a primary school? Todays monetary and financial system is
unfair, ecologically destructive and economically inefficient. The
money-must-grow imperative drives production (and thus
consumption) to higher than necessary levels. It skews economic
effort towards money out of money, and against providing real
services and goodsAt least 95% of the billions of dollars
transferred daily around the world are for purely financial
transactions, unlinked to transactions in the real economy.
[James Robertson]
Another critical repercussion of the prevailing monetary system
(which treats money as a commodity) is that the system, by
design, promotes inflation
The Equation of Exchange
MV = PY, where
M is Money Supply
V is Velocity or the number of times per year the average
dollar is spent on goods and services (assumed to be
constant)
P is the aggregate or average price level (Inflation)
Y is the real output of goods and services produced in the
economy (GDP)
Historically, growth of Money Supply (M) exceeds growth of Real
Output (Y)
This is statistically evident
Disproportionate increases in Money Supply causes Inflation
Logically, it makes sense
If you introduce more money into the economy than there are
real goods and services, the prices of these real goods and
services will increase
Inflation Caused by Increases in Money Supply
80.88 4.38 Turkey
18.69 9.43 Thailand
62.51 3.59 Uruguay
4.90 2.92 Saudi Arabia
74.15 1.10 Poland
271.95 1.15 Peru
15.92 5.26 Pakistan
6.46 4.43 Oman
31.64 4.23 Nigeria
41.90 2.50 Mexico
15.74 8.50 Malaysia
3.67 2.95 Kuwait
25.97 10.76 Indonesia
16.74 5.94 India
38.56 4.64 Ghana
28.19 9.99 China
677.76 2.57 Brazil
13.92 4.23 Bangladesh
5.65 6.15 Bahrain
181.80 2.49 Argentina
Broad Money (M2) Real GDP
Average Annual Growth Rate (1986 1996)
Country
Countries
experiencing
recent
economic and
financial crisis,
a coincidence?
Growth in Money Supply vis--vis Real Output
Before Increase in Money Supply
Farmers
Wealthy
Businessmen
Blue-Collar
Workers
RM30,000,000
RM150,000,000
RM20,000,000
Total Money Supply
RM200,000,000
200,000,000 Number of packets of nasi
lemak in the economy
RM1.00
Price of one packet of nasi
lemak
Buys 30,000,000 packets
of nasi lemak
of nasi lemak
of nasi lemak
What is so bad about inflation?
After Increase in Money Supply
Farmers
Wealthy
Businessmen
Blue-Collar
Workers
RM60,000,000
RM300,000,000
RM40,000,000
Total Money Supply
RM400,000,000
Injection of Money Supply
RM200,000,000
RM2.00
lemak
of nasi lemak
of nasi lemak
of nasi lemak
RM150,000,000
RM30,000,000
RM20,000,000
What is so bad about inflation? (2)
Substantial proportion of increase in money supply occurs via
lending by commercial banks
Bank lending practices predominantly (if not exclusively)
based on assessment of credit risk
Not based on productivity, justice or need
Other things being equal, the poor (Farmers and Blue-Collar
Workers) present a higher credit risk than the affluent
(Wealthy Businessmen)
Availability of real assets to be used as collateral
As such, in reality, the bulk of the increase in money supply
will be channeled to the affluent members of society
State Money (M0) as a proportion of
Broad Money (M2) in 1996
Country
0.18 Turkey
0.12 Thailand
0.31 Uruguay
0.21 Saudi Arabia
0.25 Poland
0.40 Peru
0.33 Pakistan
0.20 Oman
0.52 Nigeria
0.15 Mexico
0.30 Malaysia
0.06 Kuwait
0.13 Indonesia
0.31 India
0.50 Ghana
0.35 China
0.23 Brazil
0.23 Bangladesh
0.14 Bahrain
0.23 Argentina
Money Creation by Commercial Banks vis--vis State Money
After Increase in Money Supply (via Commercial Bank Lending)
Farmers
Wealthy
Businessmen
Blue-Collar
Workers
Bank
RM40,000,000
RM330,000,000
RM30,000,000
Total Money Supply
RM400,000,000
Injection of Money Supply via
Lending - RM200,000,000
RM2.00
lemak
of nasi lemak
of nasi lemak
of nasi lemak
RM180,000,000
RM10,000,000
RM10,000,000
Due to the uneven distribution of increase in
money supply (via lending), the purchasing
power of the poor diminishes
Widens the wealth disparity between the rich
and the poor
Time value of money
Time value of money (TVM) forms the basis for modern day finance
The idea that time affects the intrinsic value of money
$1 today is not the same as (worth more than) $1 tomorrow
Is this concept of time value of money acceptable in Islam?
The prohibition of riba seems to cast doubt on the relevance of TVM
Within the Islamic finance framework, the concept of TVM faces the
following objections
The basis for assigning TVM, that is, the interest rate, is arbitrarily
decided by regulatory bodies (BNM, Federal Reserve)
As such, this value seems artificial and does not originate from
natural elements
Contrast this with say, market price of a good which is determined by
market forces of demand and supply
TVM presumes a certainty of outcome (risk free rate assumed as
virtually guaranteed)
In Islam, only God knows the certainty of any outcome
TVM requires the man-made institution of interest-based lending
which Islam forbids
Would TVM exist if there were no banks and interest-based lending?
Islamic Time value of money
Given the prohibition of riba and the objections to the conventional
notion of time value of money, does this mean that Islam rejects the
concept of TVM outright?
Islam does recognize and embrace the concept of positive time
preference
All consumption and production activities take time
Time is a valuable economic resource
Opportunity cost of postponing current consumption
Current consumption brings more satisfaction than future
consumption
Hence, compensation should be made for the utility forgone
today
Opportunity cost of not being able to invest funds in productive
activity
Owner of funds gives up the possibility of earning a positive
return on funds
Islamic Time value of money (2)
There are two perspectives of the Shariahs
approach to TVM
1. The provider of funds should be compensated for
foregoing current consumption or the opportunity
to earn a positive return on investments
However, this compensation cannot be
contractually pre-determined because there is
no certainty in any outcome
Example of the application of this perspective
Contract of mudarabah the rabbal-mal has
the right to a share of the ventures profits
because he has given up current
consumption or the ability to invest the funds
elsewhere
Islamic Time value of money (3)
There are two perspectives of the Shariahs approach to TVM
2. Majority of jurists agree that price for cash sale and credit
sale can vary
In a credit sale, time is not the exclusive consideration
to determine price, but only an ancillary factor
Alternatively, one can view cash and credit sales as
having different markets and thus varying prices
resulting from different sets of demand and supply
In a sense, this implies that TVM does not apply to a
loan contract while it is applicable to sales contracts
Examples of the application of this perspective
Widespread use of murabahah (mark-up) sales in Islamic
financing wherein the credit (murabahah) price is typically
higher than the cash (spot) price
In a salam contract, the salam price is usually lower than
the spot price given the advance payment vis--vis
deferred delivery of goods

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ECON 3430 - Islamic Banking and Finance

Topic 3 - Concept of Money 1

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