Articles on Islamic Economics

Monetarists, Monetary Policy and Morality

Dr. Atiq Ur Rehman

Director, Kashmir Institute of Economics, University of AJK

Morality and Monetary Policy

‘Moral Monetary Policy’! This phrase sounds very awkward because we believe that monetary economics is a positive science and there is no relationship of the monetary policy with morality or immorality. But actually, like any other economic policy, the monetary policy has very serious moral implications. In 1974, the Nobel Prize in Economic Sciences was awarded to Gunnar Myrdal, an economist who presented “Strict Non-neutrality Thesis”, a theory which says that no action in social sciences could be free of socioeconomic implications.

Myrdal also received several honorary degrees and other prizes for linking the social sciences to their moral and normative implications. Myrdal also wrote explicitly on the socioeconomic implications of monetary policy.

The words of Myrdal were so logical that he was able to win the most prestigious prize in economics; however, unfortunately his words could not affect the behaviour of Central Bankers towards the monetary policy.

The monetary policy until today is conducted without paying any heed to the socioeconomic consequences. Despite the fact that central banks usually have very strong research wings and they are equipped with lots of resources, it is rare to find a study administered by central banks and relating the monetary policy to the socioeconomic indicators except for employment and growth.

In fact it does not require a long debate to prove that the monetary policy is having very strong association with socioeconomic indicators. The monetary policy today focuses on the inflation as the primary target of the policy. That is one half of the picture. Almost all the literature agrees that inflation is closely associated with income inequality and that is the second half of the picture. If you connect the two halves, the natural conclusion is that the monetary policy is indirectly linked to the income inequality.

Reducing income inequality is included among the Millennium and Sustainable Development Goals, the development agenda agreed upon by all the nations. So, how can economists at central banks conduct monetary policy without studying its implications for the inequality, when their country is among the signatories of Sustainable Development Goals Declaration?  But unfortunately, the monetary practice is going on in such a way that it is hard to imagine that this science is having any relationship to the morality or to the socioeconomic indicators.

Moral Implications of Inflation Targeting

The most popular monetary policy framework today is the inflation targeting framework which says that inflation is the primary focus of monetary policy and the interest rate is the main policy variable which should be used to achieve the desired level of inflation. The underlying assumption is that ‘when interest rate increases, the people start consuming less, leading to a fall in the aggregate demand which will ultimately lead to reduction in the aggregate price level’.

There are several questions on the validity of this mechanism, however. Assume for a while that the mechanism works quite well as stated in the textbooks. If so, a little deeper analysis would reveal several socio-economic implications. Why does monetary policy focus on the price level?  In the first look, it seems as if policymakers intend to protect the purchasing power of the vulnerable class of the society, but the reality is quite opposite.

Frederic Stanley Mishkin states six reasons for setting the price stability as target of monetary policy, with no mention of protecting the purchasing power of the poor people in this list. The reasons for inflation targeting as mentioned by Mishkin are stability of the fluctuation in aggregate output, transparency and communication accountability, central bank independence and harmony with the democratic principles.

Actually, the implications of inflation targeting are negative for the poorest. Suppose that the mechanism behind inflation targeting framework works and by increasing interest rate, the aggregate demand could be reduced.

Any reduction in the aggregate demand will lead to reduction in output and an increase in unemployment. This means some of the workers may lose their jobs. Who could be more vulnerable to increased pressure of unemployment? It would be people among the temporary employees, daily wage workers and small entrepreneurs who will suffer the consequence of reduction in aggregate output.

Those who belong to upper income percentiles, they are capable to protect themselves against unemployment. A 1% increase in total unemployment in a country actually means a greater than unity percentage increase in unemployment for the poorest cohort of the society. Is it making sense to victimize the poorest cohort of the society for the financial stability which will actually benefit the upper class of the society? This is a serious question mark which is not usually addressed.

Moral Implication of Demand Channel

Now think about the monetary policy from another angle. Suppose that the mechanism behind the inflation targeting framework is actually working as stated in the textbooks, i.e. an increase in the interest rate can reduce inflation by reducing the aggregate demand.

It is obvious that reduction in the aggregate demand can occur only due to reduction in demand of luxuries. Any reduction in the demand of necessities is neither possible nor desirable. We will never want to reduce the consumption of wheat and grains to bring the price stability. Therefore, if any reduction in the aggregate prices occurs, it will be driven by the prices of luxuries.

This means the relative income of those who are having larger portion of luxuries in their consumption basket would be protected. This means that the policy will lead to increased income inequality. This is another normative and socioeconomic implication of monetary policy which is never discussed in the monetary literature.

Monetary Policy and Public Debt

The major reason for increase in interest rate as stated in the statements of central banks is to control inflation. But that’s one aspect; on the flip side, it can be observed that many nations have borrowed extensively from their commercial banks for their day-to-day operations. For some countries, the debt to GDP ratio is more than 100%.

Few banks and financial institutions are allowed to participate in trading the government securities which are the government’s borrowing instruments. The mark-up on these securities is closely associated with the official interest rate and higher interest rate would lead to higher mark-up payments. The investors in the government securities would be directly benefited from this increase in the mark-up payment.

During 2018-19, the policy rate in Pakistan was increased from 5.75% to 13.25%, doubling the allocation for mark-up payments and the justification for this increase was to fight inflation. As a result, the allocation for mark-up payments jumped to 42% of the federal budget. So in order to protect the price stability, billions of rupees were paid to the richest bankers. Isn’t it making more sense to pay these amounts to the people belonging to the bottom 20% income group to protect them against the loss of purchasing power? But, like many other question marks, there is no reply to this question as well.

Sectarianism in Economics

Economics is usually presented as a positive science and a positive science should go with facts and realities. But, unfortunately that is not the case, especially in the monetary economics. Monetary economists behave like religious devotees belonging to a particular sect who will defend all the beliefs of their own sect and will ignore and undermine all the theories and explanations coming from the opposite sect. One dominant sect or religion is allowed to take part in the policy making and the theories and beliefs of opposite sects are never brought to the limelight.

One of the oldest theories in monetary economics is the Banking School Theory presented by Thomas Tooke in 1838. This theory says that relationship between interest rate and inflation should be positive.

The logic is very simple and understandable, i.e. the interest rate is a part of cost of production. The firms need working capital to produce goods and services and they borrow working capital from the banks. Increase in the interest rate means increase in the cost of the working capital and the firms will transfer this cost to the customer leading to higher equilibrium prices. This was one belief which had the simple and understandable logic to support it.

But the dominant majority of economists adopted another view, known as the Demand Channel of Monetary Transmission Mechanism. They argued that if interest rate is going up, then people will postpone some of their spending decisions and the aggregate demand in the economy will decrease. This reduction will lead to reduction in the equilibrium price level.

Both the Banking School’s Cost Channel and the mainstream Demand Channel make sense, but the theory of demand channel won patronage of the dominant economic religion. Therefore, it was portrayed in such a way that it appears to be the only existing theory relating the interest rate to prices.

On the other hand, the empirical evidence in every era had been supporting the view of Tooke’s Banking School theory and this viewpoint was unacceptable for the mainstream economists. Therefore, it was totally undermined and ignored in such a way that most of the economists are unaware of even the existence of this view.

Gibson (1923) analyzed a very large data set of United Kingdom and found that the relationship between interest rate and price level is positive. This was such a strong observation that John Maynard Keynes considered it as ‘most established fact in the whole field of quantitative economics’. However, despite recognizing the significance of this finding, Keynes termed this observation as Gibson Paradox, which indicates that the observation was not explainable by using economic theory.

But the fact is that this finding was actually supporting one of the oldest theories of monetary economics i.e. the Banking School Theory. About 70 years later, Nobel Laureate Christopher Sims found similar results and his findings were termed as Price Puzzle to indicate the lack of theory explaining the phenomena. But, the two authors actually found the support for the oldest theory in monetary economics.

Later on, Barth and Ramay (2001) explained the phenomenon by using the cost channel. Since then, there have been numerous evidences supporting the view of Thomas Tooke. Many central banks also conducted research on the existence of cost channel and found the evidences for the channel. However, until today, central banks never included the cost channel in their inflation models.

Existence of Cost Channel actually means that the contemporary monetary policy is counterproductive.  If you want to achieve a certain target, the policy action will lead you to exactly the opposite direction. Therefore, in an objective science, the support from historical data should decide the nature of relationship between the two variables and the policy should follow the findings of historical data. But since the cost channel belongs to a different economic religion, no heed is paid to the existence of cost channel in the Central Bank models and policies.

Behaviour of International Financial Institutions

Finally, the behaviour of international financial institutions also implies the dual standards of these institutions. These institutions have two different sets of economics, one for their masters and one for their slaves. All the countries having influence on the international financial institutions are practicing the quantitative easing today to deal with the problem created by COVID-19 pandemic.

On the other hand, all the countries under the influence of these institutions are being advised to follow the inflation targeting for their policy making. In fact, the influential countries who adopted inflation targeting regime as the legal mandate of their central banks, even they have abandoned the practice of inflation targeting during the pandemic.

But, when it comes to the countries who owe the debt to IMF and World Bank, the advice is ‘stick with the inflation targeting’, despite the fact that there is no solid historical evidence to support the inflation targeting framework.


Barth, M. J., & Ramey, V. A. (2001). The Cost Channel of Monetary Transmission. NBER Macroeconomics Annual 2001.

Gibson, A. H. (1923). The Future Course of High Class Investment Values, Banker’s Magazine, 115(946), 15 – 34.

Tooke, T (1838), A History of Prices, and the State of the Circulation, from 1793 to 1837. London: Printed for Longman, Orme, Brown, Green, and Longmanís.

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