Providing an Islamic approach of monetary systems

Purpose The purpose of this paper is organized as follows. Section 2 reviews the literature on the subject matter, focusing on western economic literature and the Islamic economic paradigm, including the Quran, Sunnah, jurisprudence and Islamic philosophy thinking, to illustrate the origins of the Islamic approach to monetary systems. The money interest rate and its studies are explained, and the role of money and credit in the production function is considered. Then, it is shown that money maintains the demand for money in the overlapping generation model, as well as the consumption behavior of households. It is followed by an explanation of general Pareto optimality and the role of the money interest rate in inefficiency and nonoptimality for households and firms. Finally, Section 4 concludes the paper. Design/methodology/approach This paper studies the effects of money issuance and bank creation on Pareto optimality. In explaining the origins of the Islamic approach to monetary systems, the literature review, it focuses on western economics’ literature and Islamic economics paradigms such as the Quran, sunnah, jurisprudence and Islamic philosophy thinking. In modeling section, the authors show how banks’ fractional reserve credit is profitable. The authors also examine how the introduction of the money interest rate can change the Pareto optimality. In this regard, the comparison between two situations, namely, financing by the stock of money and borrowing in the credit market, indicates that welfare is reduced by the creation system and is inefficient (or nonoptimal). The result is that no money and no credits are created. The provision of this system compensates money by increasing the real money supply or deflation. To ensure Pareto optimality, it has been proven in the field of microfoundation that there should be no fixed money contracts and no money interest rates. It is necessary that the interest rate on consumption credit is zero or Qarz-al-Hasna is broken. Moreover, profit sharing is offered in the production sector. Findings As a result, the authors proved mathematically that the money interest rate must be zero to ensure productivity and Pareto optimality. On the other hand, the introduction of money or credit through loanable money leads to inefficiency, both in production and households and in the general equilibrium. The inflation generated by the credit system stimulates the change in the price level and perpetuates this inefficiency. Thus, if the authors want to return to the optimality condition, the interest rate on consumption credit must be zero or Qarz-al-Hasna is breached. However, the behavior of the fractional banking system and the credit mechanism teaches us that the money interest rate is an integral part of credit and loanable funds. Thus, the elimination of the money interest rate from the banking system without bank creation is implausible. Finally, to ensure Pareto optimality, it has been mathematically proven in the field of microfoundation that there should be no fixed money contracts and no money interest rate. It is necessary that the interest rate on consumption credit is zero, or Qarz-al-Hasna is broken. Moreover, profit sharing is offered in the production sector. The result is that no money and credit are created. The provision of this system compensates money by increasing the real money supply or deflation. Originality/value The capitalist theory of the definition of interest plays a decisive role in economic science. In this context, the authors are dealing with different vocabularies and terms for the interest rate. These different vocabularies have their origin in the different economic situations and especially determine the thinking of the schools. Because of the relationship between future and spot, the authors have to transform the variable “level” into the variable “interest rate” in the dynamic space. Finally, the exact explanations for the movement and evaluation of the economy are revealed by the correlation of the different interest rates.