MBF707: Monetary and Fiscal Framework in Islamic Finance

MBF707: Monetary and Fiscal Framework in Islamic Finance COMSATS Institute of Information Technology (Virtual Campus)

Lecture 20FISCAL POLICY: ISLAMIC VERSUS CONVENTIONAL(continued)

Review of the Last Lecture

Topics to Cover • INTRODUCTION (ROLE OF THE GOVERNMENT IN ISLAM) • FISCAL POLICY (IN CONVENTIONAL PERSPECTIVE) • WITH KEYNESIAN TEORY • IN ISLAM PERSPECTIVE • EARLY ISLAMIC PERIOD • CONCLUSION

The Beginning of FP Keynesian economics • In criticizing the classical economist, J.M Keynes (1936) says that there is not enough demand in the market. • In his explanation of short run, it is the demand for goods and services that will determine the level of GDP, rather than the supply of factor inputs. • The Great Depression was a result of low spending by consumer and business. • The spendings were not enough to bring back the economy to full employment. The only way to raise demand and GDP is increasing government spending.

The Beginning of FP Keynesian economics • A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes) • I = planned investment • E = C + I + G = planned expenditure • Y = real GDP = actual expenditure

E =C +I +G MPC 1 Graphing planned expenditure E planned expenditure income, output,Y

E At Y1, there is now an unplanned drop in inventory… E =C +I +G2 E =C +I +G1 G Y E1 = Y1 E2 = Y2 Y An increase in government purchases E =Y …so firms increase output, and income rises toward a new equilibrium.

Solve for Y : Solving for Y equilibrium condition in changes because I exogenous because C= MPCY Collect terms with Yon the left side of the equals sign:

The government purchases multiplier Definition: the increase in income resulting from a $1 increase in G. In this model, the govt purchases multiplier equals Example: If MPC = 0.8, then An increase in G causes income to increase 5 times as much!

Why the multiplier is greater than 1 • Initially, the increase in G causes an equal increase in Y:Y = G. • But Y  C  furtherY  furtherC  furtherY • So the final impact on income is much bigger than the initial G.

E E =Y E =C1+I +G E =C2+I +G At Y1, there is now an unplanned inventory buildup… C = MPC T Y E2 = Y2 E1 = Y1 Y An increase in taxes Initially, the tax increase reduces consumption, and therefore E: …so firms reduce output, and income falls toward a new equilibrium

Supply-side Economics • In 1980’s American economy was hit by stagflation. Most of the economists blamed over-regulation, decreasing productivity and motivation to increase output among producers. • Neoclassical economic thinking surfaced in the disguise of supply-side economics calling for changes in taxes to produce more output than increasing economic activity.

Role of Government in Islam • In the traditional economics, government is only a tool. Only when market is found inefficient or it fails to generate efficiency, the government will intervene to set things straight again. • However government in Islam is divinely inspired and thus, inherent in nature. This is because, man is economic agent, functioning as consumers and suppliers alike; by nature man is weak and unstable. This has been mentioned in al-Quran (70: 19-21). • Another verse is (4:128) man is greedy and selfish. • Therefore, unlike conventional system, Islamic economics is not just material calculation of fiscal policy but also spiritual values support to increase the country performance.

Fiscal Policy in Islamic Perspective • Quran has guides what a good fiscal policy should be like. Surah Yusuf (12:43-49) tells the story of a Pharaoh in Egypt who had a strange dream. • The king of Egypt shares his horrible dream with his subjects but none of them could interpret it.. Then Yousuf, the holy prophet of Allah was contacted to interpret it. The Prophet of Allah forecast famine for couple of years in the future. The king surrendered and handed over the kindom to Yousuf to manage the situation which he did very successfully. .

Fiscal Policy in Islamic Perspective In the dream, the King saw seven green ears of wheat and seven withered or dying ears of wheat. Then prophet Yusuf interpret the dreams. Prophet Yusuf said that Egypt would enjoy seven years of prosperity with abundant harvests. In modern times, this mean high economic growth. He advised the people of Egypt to work hard in planting their crops, use a little for food and sustenance and store the rest. This is because after the period of prosperity, Egypt would suffer from drought for seven years when no crops would grow. In modern term this mean a bad long recession. But with the reserve in store, the people of Egypt could survive the seven bad years. Prophet Yusuf add more advice to the King, have to lease the best portions for seeds to plant later when rains filled the Nile. In other words, people must set aside money for savings and investment. To postpone current consumption to make way for production of future goods was one of the main messages that Prophet Yusuf wanted the Pharaoh to think about.

Fiscal Policy in Islamic Perspective • Quran advises a simple budget policy. • During economic booms, save part of the profit, call for higher savings rather than higher spending. • During good years, government normally collects higher tax revenues. • According to Prophet Yusuf’s fiscal planning, the government should not forget that the economy might eventually slow down one day. • It is good policy not to overspend such that more revenues can be set aside as reserve.

Fiscal Policy in Islamic Perspective • During a recession however, Keynesian theory suggests higher government spending to help stimulate aggregate demand. But how can we increase public spending if fewer reserves are available for government spending. • Bad fiscal policy allows government to overspend during economic booms, leaving them with lower reserves to work with when the country recedes into a major slow down.

Fiscal Policy in Islamic Perspective • The government manipulate taxes and spending such that consumption and investment behavior help to achieve full-employment level of output and price stability. • In case of recession, declining sales, output and employment, economic theory suggests more spending. • More spending will increase production, employment and income. One way to increase spending is to reduce taxes. Lower personal income tax will increase disposable income and therefore raising consumption. • Lower corporate tax will increase net profit, which can increase more business spending. • Does Islam allow manipulating taxes and zakat? Taxes can be manipulated but zakat is a fixed levy @2.5%.

Traditional Revenue Sources of Islamic State

MOBILIZING BAITULMAL’S ASSETS FOR ECONOMY RECOVERY • According to Keynes, the level of output (GDP) is determined by demand. More demand for goods and services by consumers, business and government means higher spending, which will stimulate production, thus increasing output and employment. • To increase aggregate demand, based on monetary policy SBP intervention in the money market in decreasing the KIBOR. At lower base lending rate, banks are expected to make more loans as the demand for financing is also expected to increase. • Low interest rate, investment and the GDP are expected to go up. But what if the contrary is true, that is investment is interest inelastic or not sensitive to interest rate.

MOBILIZING BAITULMAL’S ASSETS FOR ECONOMY RECOVERY • Even at low interest rates it does not mean that banks are willing to make more loans. The supply of loans too may be insensitive to interest rates due to fear of more bad debts if new loans are made. • However, Islamic economic institutions in this country could do their part, especially those who are currently holding abundant supply of assets and cash. Here the BaitulMal(Islamic treasury) can do its noble part, especially in providing capital and land resources.

MOBILIZING BAITULMAL’S ASSETS FOR ECONOMY RECOVERY • Islamic public assets such as zakat funds and waqf properties are available on a large scale. If this public assets are difficult to mobilize on a grand scale, which finally all Muslims will stand to lose. If those assets are properly utilized so that more benefits can be generated from them. • In Pakistan & Malaysia, there are a lot of waqf land that have been misused; kept idle; failing to collect rent from tenants and even gazetting these lands for the purpose of economic utilization. • Education and learning is a scarce commodity today, so those waqf properties may help to solve the problem. • However, without capital, waqaf properties can not be mobilized. • Zakat is another source of economic growth. It is actually a tax on assets that are growing or increasing in size. Zakat is obligation not a personal thing. The state has a legal claim on this tax, which include zakat tax on wealth, income and agriculture produce.

MOBILIZING BAITULMAL’S ASSETS FOR ECONOMY RECOVERY • Among the eight heads of zakat spending, for fisabilillah purpose is so wide that ijtihadcan be made on how zakat funds can put with full force to improve the life of Muslims and mankind. Spending for the way of Allah can be source of many things such as education, national defense, communication and infrastructure development. • Surplus of zakat and idle amount of waqf lands are revived to the maximum advantage of Muslims. Doing so will stimulate the demand for raw material and labor, which brings more jobs and value-added activities to the local economy and thus help economics recovery. • And there will be sufficient projects for contractors as well as other interested parties.

Conclusions • Macroeconomic policies in Islam can indeed cover a wide array of topics, this lecture addresses a few. • The Islamic economic system must in the first place ensure economic justice in economic transactions. • This will make macroeconomic management to be pursued to the minimum while the state will always be in constant surveillance to see that economic growth and stability is guarantees and secured. • If governments failed to exercise restraint on excessive expenditures during good times, they will have no choice but to intensify fiscal policy to stimulate spending when recession hits the country.

Conclusions • Conventional theories are emphasize much more on analyzing the consumer behavior to protect economy from economic problems creating inflation, deflation and stagflation (more materialistic). Their focus is to maximize profit and minimize losses. • However in Islam, it not only stresses on material growth and well-being but also spiritual growth. The system is based on justice; it stimulates zakat and waqf to improve the economic society. • Saving and investment are really important during economic boom in the light of Quranic education narrated in surah Yusuff. • The benefits of savings in good times turn into investment and accrue benefits during economic recession.

Thank You

MBF707: Monetary and Fiscal Framework in Islamic Finance