ALLOWING FOR INFLATION AND TAXATION Q1. Ethan Co is evaluating Project Z, which requires an initial investment of $45,000. Expected net cash flows are $16,000 per annum for two years….
Maintaining inflation in conventional system: A comparative analysis of Middle Eastern countries
This research project analyses the extent to how the Islamic system can reduce inflation in the conventional system. In particular, the research focuses on the factors to which promote and maintain inflation within our society.
Inflation is defined as the sustained upward trend in the level of prices and is most commonly measured using the percentage rate of change in a country’s Consumer Price Index (CPI). Aggregate demand oversteps aggregate supply at full capacity, which results in continual price rises. (Siddiqi, 1996)
Using the UK as a model, a report from the National Statistics Online (2011) states, the increase in the VAT to 20% and the continued price increase in crude oil were the factors that contributed to the increase in the inflation rate during January.
The governments are always playing a critical game with inflation; it erodes the value of the public debt mountain. Economic stability is quite responsive to government actions and regulations.
Economic growth is influenced by low inflation in countries where there are wage and price strictness. However, very high inflation and hyperinflation destroy an economy bringing about economic hardship, poverty and political disasters. (Choudhary, 2007; Hossain, 2009).
Inflation is worrying since for most people this means less consuming and saving. As inflation increases the cost of living rises. If your income is not increasing at the same rate of inflation, then you will not be able to live at the standard you currently enjoy. Future planning is difficult due to the greater uncertainty in future prices. Many of us students who all fit into the middle class society will be the most affected. The needy can rely on state benefits while the well-off can take advantage of the inflated asset market with capital growth.
The distribution of income and wealth to the poor is distorted by inflation and many economists have established a negative relationship between inflation and growth of productivity. Hence, real growth is hindered due to the negative effects on saving and investment.
According to Cheng & Tan (2002), in order to successfully solve the inflation problem, accurate assessment of the causes of the problem is critical, as wrong diagnosis of the nature of the problem will lead to adverse effects on the economy. Inflation can have a very damaging effect on economies over the long term.
Despite the growing interest and the rapid growth of the Islamic banking and finance industry, analysis of Islamic banking at cross-country level is still at its infancy. (Sufian & Noor, 2009). There is a general lack of understanding in the literature and so the purpose of this research is to fill the gap in existing research
Section 2 reviews the existing literature on how the Islamic economy can reduce inflation. Section 3 discusses the research questions and is followed by research methodlogy in Section 4.
1. Literature Review 977
Many earlier studies of how inflation can be reduced by implementing Islamic economy exist. However, a review of this literature reveals inconsistent findings, little direct comparison between inflation and the Islamic system and little investigation of the use of techniques for inflation. In addition, limited empirical work is visible. The following literature summary highlights the inconsistencies and gaps that indicated the need for the current study.
Using a model, Bashir (2002) proved that the government in an Islamic economy could implement fiscal policy using the Zakat. With the Zakat rate being fixed, this reduces the distortion created by variation in the tax rate. The collection of Zakat and money creation can be used to finance public sector projects and/or finance the budget deficit. To boost growth, monetary and fiscal policies should be closely coordinated. However, the model only assumes this works in a smaller, closed economy in a pure profit-sharing environment.
Kia’s (nd) analysis included a comparison of the GDP of two countries, Iran, operating under the Islamic economic system and Turkey, operating under the conventional economic system. His results showed that Iran had a negative GDP and Turkey had a positive GDP. His results were not very clear since a negative GDP indicates an economy is in recession, whereas a high GDP indicates economic prosperity, but also indicates inflation.
Darrat (1988) verified the relative efficiency and stability of Islamic banking in Tunisia. He showed that the banking system of Tunisia becomes more stable without interest-bearing assets that if these assets were to exist. However, his study lacked reliable data, which was not available for several Muslim countries.
The design of Siddiqi’s (1996) study offers the best framework upon which built in stabilisers are a feature of the Islamic economy, which guarantees zero inflation or at least minimises its incidence.
Four built in stabilisers are included in the current study and are outlined below.
1. Debt financing
One of the main causes of inflation is the debt financing which is replaced by equity and share based financing. Once fully implemented, this would automatically give us a world where no inflation, no unemployment, no exploitation and no poverty exist. (Khan, 2010)
According to Zarqa (2009), this view is also supported by Henry Simon, an American prominent economist, who believes that if no resort were made to short-term borrowing and if equity investments were held, the danger of economic instability would be minimised.
Debt creation in Islamic finance is generally with the backing of goods and services. Monetary expansions would therefore tend to take place in step with the growth of the real economy. This expected to control inflationary pressures. (Iqbal & Ahmad 2005; p7)
Taxation is acceptable within an Islamic economy; however, the role of Zakat as an Islamic tax is fundamental. Every Muslim who enjoys excess wealth must pay this to fulfill the Islamic obligations. Those who are in need can take advantage of Zakat, a 2.5% tax on fixed assets which is paid annually to the poor.
We know companies regularly hoard essential items in an attempt to artificially affect supply and demand in order to push up prices. This usually happens with the knowledge of the government.
The Islamic system discourages waste and encourages moderation in consumption. This will result in aggregate demand.
4. Reduction in public expenditure
Islamic governments consider public money as trust. Consequently, they must keep public expenditure within the bounds set by the available means. Public financing of government debt is very rare as predetermined interest rates do not exist and in case of financing debt/deficits, the rate should be attached to the growth of the economy. Monetisation of debt/deficits in Islamic economic systems is almost nonexistent. (Kia, nd)
Besides these built-in stabilisers, other factors may affect the rate of inflation. Firstly, whenever the Government borrows money it artificially creates currency by printing more money, which in effect devalues the currency. This has a knock on effect on inflation. The direct casual link between interest and inflation is very clear from the credit creation of the central banks. It proves that the more money there is in circulation to pay for the same amount of goods, the more prices go up. So eliminating interest-which is what the Muslims are called upon to do-would mean reducing inflation. (Hassan & Chachi 2005; p63)
Secondly, banks regularly loan out more money than they have in circulation, which effectively creates artificial money. This leads to inflation since there is an increase in money supply, which is in turn, competing in chasing limited goods.
In addition, the cost of energy resources is linked to pricing and inflation. High energy costs are affected by government taxes and the drive for profits by hungry companies. This contributes to inflation.
Finally, barren land presents an incentive for poor farmers and others to take advantage of the Islamic rule and revive dead land and the whole state would benefit. Poverty would be reduced, employment would increase and so would production.
In the literature review, factors contributing to inflation in the conventional system have been looked into and how the Islamic system is different and how it works within the economy has been explained.
2. Research Questions 488
The preceding discussion has revealed two key issues in regard to the analysis of inflation in conventional systems. Darrat (1988) had issues with collecting his data which was reliable enough for his study. Also, Kia (nd) had unexpected results although both countries investigated were from the Islamic and the conventional system.
Due to looking to identify correlations and compare different variables, a great deal of archival work will take place.
Given the increasing instability in the conventional economy, the research questions addressed in the study were formed by the gaps discovered in existing literature and can be broadly categorised as follows:
Question 1: How will applying the Islamic system contribute to the reduction in inflation in conventional system?
Examining the features of the Islamic system will provide insight into what is different about the system and how Ilsmaic countries are contorlling inflaiton within their countries.
In the literature review, we have already looked at the built-in stabilisers introduced by Siddiqi’s (1996) study. The framework has answered the main points; however, the research will expand on the points. The questions is easily and fully researchable and will require the use of secondary data, such as government publications and statistics to look at trends.
Therefore, throughout this study the built-in stabilisers will be examined very closely regarding the cause of inflation.
This question arises from a synthesis of a number of bodies of literature.
Question 2: Is there a significant difference between inflation in Western countries as compared to Islamic countries implementing Islamic economy?
Examining the difference between infation between the Islamic and conventional system will provide an insight of …
Time does not permit the analysis of all the countries in the world; therefore, focus will be on a sample of countries that have been the most successful, domestically and internationally. Determination of which countries to use will depend on the statistics from governmental and non-governmental agencies.
Comparative analysis will be used to find differences in the inflation rate between both systems. Internet resources and government statistics will have the answer to my research question.
Looking at the gap in the literature review, no author has carried out a comparative analysis on this topic yet.
Question 3: What major trends are going to matter the most during the next decade?
This objective will be the result of objectives 1 and 2 and will be a forecast of what will be expected to happen in the coming years.
Section 4 outlines the research methodology which will be used in the study.
3. Research Methodology 977
This section presents an outline of the methods to be used in this study. Areas that will be covered include the research design, sample and sampling techniques, data collection and analysis.
1. Research design
As a result, the research will be designed to answer the research questions set out in the previous section using quanititative and qualitative data.
Quantitative data will be used to assess the inflation rates of the sample countries, which will be analysed statistically using exploratory data analysis. Whereas, the qualitative research question will be answered using established literature, such as government publications and statistics from the sample countries.
2. Sample and sampling techniques
The population that is accessible to this study consists of countries from both Islamic and conventional systems.
Convenience sampling, a type of non-probability sampling method, was used; our sample consisted of fewer than 20 countries and this method seemed to be less time-consuming.
Middle Eastern countries were selected for comparison of the Islamic system since majority of the assets of Islamic banks are held in the Middle Eastern region.
The purpose was to see how big the differences were in the inflation rate between samples of countries from both systems.
The middle-eastern countries included in the study are Bahrain, Iran, Jordan, Kuwait, Lebanon, Qatar, Saudi Arabia and United Arab of Emirates (UAE).
However, the set of countries within the conventional system is widely diverse, therefore, it is essential that the countries are characterised. The top eight countries with the largest consumer markets were chosen for inclusion in the study. The conventional countries include United States of America (USA), Japan, Germany, China, France, United Kingdom (UK), Italy and Brazil.
This resulted in a sample size of 16 countries of the study.
3. Data collection and analysis
The study was conceived of as fundamentally exploratory in nature, reflecting the lack of empirical research evidence concerning the idea of reducing inflation within the conventional system. The choice of reviewing available data as the principal method of data collection is justified by the exploratory nature of the study being undertaken.
Existing records will be looked at for the sole purpose of understanding what can be derived from the results. In addition, due to the scarcity of the data involved, the research will be mainly multiple source secondary data, which should enhance existing studies. In addition, using existing records is less costly and time consuming, in which this valuable time could be spent on collecting the data. Finally, it can be much quicker to obtain information from the source and will provides larger and higher-quality data than if data was to be collected by yourself. It is impossible to conduct a new survet that can adequately capture past change and developments within the sample countries.
This should be available from the Internet, if not; data will need to be requested from the government of the sample countries. The data available will depend on whether granted access is available.
Comparative analysis of existing records will be used between the inflation rate of countries implementing Islamic and the conventional system to prove the effectiveness of the Islamic economy.
Because different measures of inflation exist, eight measures of inflation will be used in this study and are as follows:
Consumer Price Index (CPI)
Producer Price Indices (PPI)
Commodity Price Indices
Core Price Indices
Asset price inflation
Quanititative data will be analysed by restructuring the data.
The analysis of quantitative data will be using descriptive statistics. This type of analysis is recommended since the objective of the study is to describe and discuss a data more generally and conveniently than would be possible using raw data alone.
Median will be used to represent the frequency distributions to locate the mid points of what the inflation rate is for both systems. The inflation rates will be arranged in order of magnitude and the formula (M+1)/2 will be used to find the middle value.
Range will be used to represent the measure of dispersion which indicates how spread out the data is from the mean.
Charts and line graphs will be used to present and summarise the data collected. This will help display and communicate the data effectively. Line graph, in particular, enables comparisons to be made very clearly and allows a number of graphs to be superimposed on the same axes. In the study, we will be doing this for each inflation measure.
Qualitative analysis will be the basis of the research, which will include the presentation, and analysis of a group of findings retrieved by other studies in the literature. Trend data should give a useful indication about the status of inflation in the Islamic and conventional system, which will be achieved by watching for trends and current actions in the news.
Secondary sources, such as statistical indexes, graphs, tables of primary data, will be presented in order to support the views of the literature and the personal assumptions on the topic.
With the wealth of background work of secondary data, this type of data has a profound degree of validity and reliability which does not require further examination by the researcher using the data.
To do before submitting:
Presentation in G608
(10-15 sources-books and journal articles)
Bashir, AM. (2002). The welfare effects of inflation and financial innovation in a model of economic growth. Journal of Economic Studies, 29(1), 21. Retrieved from EBSCOhost.
Bokare, DG. (n.d). Merits and Demerits of Islamic Banking. Available: http://www.islamicvoice.com/june.97/economy.htm. [Accessed 15 March 2011].
Cheng, M & Tan, H. (2002). Inflation in Malaysia. International Journal of Social Economics. 29 (5), 411-425.
Choudhary, M. (2007). Development of Islamic economic and social thought. In: Hassan, M & Lewis, M Handbook of Islamic Banking. Gloucestershire: Edward Elgar. 21-37.
Dadgar, Y. (2005). An Analysis of the Relationship between the Interest-free Financing System and Sustainable Development: The Case of Iran. In: Iqbal, M & Ahmad, A. Islamic Finance and Economic Development. Hampshire: Palgrave Macmillan. 116-139
Darrat, Ali F. (1988).The Islamic Interest-Free Banking System: Some Empirical Evidence, Applied Economics, 20. pp. 417-425.
Du, W. (2011). The investigation on the relationship between the problem of long-term loan and economic growth. China Finance Review International. 1 (2), 187-198.
Hassan, A & Chachi, A. (2005). The Role of Islamic Financial Institutions in Sustainable Development. In: Iqbal, M & Ahmad, A Islamic Finance and Economic Development. Hampshire: Palgrave Macmillan. 59-93.
Hossain, A (2009). Central Banking and Monetary Policy in the Asia-Pacific. Gloucestershire, UK: Edward Elgar. 1-307.
Iqbal, M & Ahmad, A. (2005). Introduction. In: Iqbal, M & Ahmad, A Islamic Finance and Economic Development. Hampshire: Palgrave Macmillan. 1-15.
Khan, M & Mirakhor, A. (1989). The Financial System and Monetary Policy in an Islamic Economy. JKAU: Islamic Econ. 1 (1), 39-57.
Khan, F. (2010). How ‘Islamic’ is Islamic Banking?. Journal of Economic Behaviour & Organisation. 76, 805-820.
Kia, A. (nd). Inflation: Islamic and Conventional Economic Systems. Finance and Economics Department, Utah Valley University, USA. Working Paper 1-08. Available from http://www.uvu.edu/woodbury/faculty/WorkingPaper1.pdf. [Accessed 8 March 2011].
National Statistics Online. (2011). Inflation. Available: http://www.statistics.gov.uk/cci/nugget.asp?id=19. [Accessed 10 March 2011].
Siddiqi, Muhammad Nejatullah (1996). Role of Fiscal Policy in Controlling Inflation in Islamic
Framework, King Abdulaziz University, an unpublished manuscript. Avaialable from http://www.siddiqi.com/mns/FiscalPolicy.html. [Accessed 8 March 2011].
Sufian, F & Noor, M. (2009). The determinants of Islamic bank’s efficiency changes: Empirical evidence from the MENA and Asian banking sector. International Journal of Islamic and Middle Eastern Finance and Management. 2 (2), 120-138.
Wilson, R. (1982). Economic Change and Re-Interpretation of Islamic Social Values. British Society for Middle Eastern Studies. 9 (2), 107-113.
Zarqa, M.A. (2009). Stability in an Interest-Free Islamic Economy. Issues in the International Financial Crisis from an Islamic Perspective. 243-252. Available from