Financial Stability and Monetary Framework under Interest-Free  DSGE Settings for Pakistan

Rao Javaid Iqbal; Atiquzzafar Khan; Hafiz Muhammad  Yasin

doi:10.32350/ibfr.102.05

Rao Javaid Iqbal International Islamic University Islamabad https://orcid.org/0000-0001-6175-7726
Atiquzzafar Khan Riphah International University, Islamabad
Hafiz Muhammad Yasin International Islamic University, Islamabad

DOI: https://doi.org/10.32350/ibfr.102.05

Keywords: financial stability, Islamic DSGE, DSGE Pakistan, Macro-financial DSGE, Monetary Policy, Small Closed Economy DSGE, Interest-free DSGE, Financial Accelerator, Macroprudential Policy, Islamic Central Banking, Central Banking

Abstract

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Various small and large, conventional and interest-free, DSGE models have
been developed, simulated, and compared. After a large conventional
model, an interest-free NK model was prepared with household preferences,
retail firms, and capital-producing firms. The deduction of zakat was
suggested with appropriate incidence. The model was estimated using
quarterly data for Pakistan between 1990 and 2009, a period characterized
by the consolidation of monetary and macro-prudential policies besides the
opening up of the banking sector. This large-scale model included financial
accelerator, systemic risk, the inter-bank market, macro-prudential policy,
and monetary policy. Both types, that is, interest-based conventional models
and interest-free models, were estimated and compared. The welfare loss of
four conventional and three interest-free models was computed and
compared, where loss decreased with monetary policy and increased with
money in utility. The lower value of welfare loss for the large conventional
model exhibited effective financial stability policies in Pakistan, as
compared to the basic model. It was found that interest-free monetary
models couldn’t reduce welfare loss, when compared with conventional
models. The study also evaluated three interest-free rates of return as
alternatives to interest rates theorized by Khan and Mirakhor (1989). It was
found that the shift towards an interest-free regime for entrepreneurs,
banking, inter-bank operations, central banking, and policies can be
simulated with Pakistan’s data. The Islamic model showed lesser
convergence, so the fit of the model was reduced.

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