Tuesday

 

Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed.
PART 9 The Real Economy in the Long Run
Chapter 26 of 36 Saving, Investment, and the Financial System
Section 2 of 25
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Imagine you start your own business, an economic forecasting firm.
Before you can produce and sell forecasts, you must incur substantial set-up costs.
You have to buy computers, furniture, and various equipment.
Each of these is a type of capital good your firm will use to create and sell forecasting services.
Where do you get the funds to invest in the needed capital goods?
Maybe you have enough savings to pay for all of them.
More likely you do not have enough of your own money to finance your business startup.
So, you have to get the needed money from other sources.
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There are various ways to finance capital investments.
You could borrow the money from a bank, friend, or relative.
With this you promise return the borrowed money at a later date and also pay interest for use of the money.
You could convince people to invest money, buy shares, in exchange for a portion of your future profits.
In both cases your investment in computers and office equipment is being financed by someone else's saving.
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The financial system consists of institutions that help match one person's saving with another person's investment
Saving and investment are key ingredients to economic growth.
When a country saves a large amount of its GDP more resources are available for capital investment.
Increased capital raises a country's productivity and living standard.
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At all times financing is available (supplied) and needed (demanded).
Some people want to save rather than spend some of their income.
Other people want to borrow to finance new and growing businesses.
The financial system is the market that brings these two groups together.
The financial system ensures the supply of funds of those who save balances the demand for funds of those who invest.
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In this chapter we examine how the financial system works.
First, we discuss the various financial system institutions in our economy, including banks and the stock market.
Second, we discuss the relationship between the financial system and some key macroeconomic variables.
The main variables are saving and investment.
Third, we develop a model of supply and demand for funds in financial markets.
In the model the interest rate is the price that adjusts to balance supply and demand.
The model shows how various government policies affect the interest rate and thereby, the economy’s allocation of scarce resources.
… …
Why do Islamic societies consider charging interest to be unethical?
It's a price - for use of money.
ChatGPT:
Yes, money has a price, so interest, “riba,” is that price.
But classical Islamic thought starts from a different premise, so it reaches a different conclusion.
The core idea: money isn’t supposed to “grow by itself”
In Islamic law, the prohibition of riba comes from the Qur'an and later legal interpretation.
The key distinction is:
Trade/profit (allowed): you take risk, add value, or participate in real economic activity
Interest (forbidden): you earn a guaranteed return just for lending money
So the objection isn’t “price is bad”—it’s:
Money itself shouldn’t generate a risk-free return without participating in real economic activity.
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The fairness argument
Traditional reasoning says interest can be unjust because:
The lender is guaranteed profit.
The borrower bears the risk — business might fail, income might drop
From this view, that’s an imbalanced contract:
One side wins no matter what
The other can lose everything
Islamic finance tries, at least in theory, to favor shared risk-sharing, both sides gain or lose together.
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Historical context matters
When these rules developed:
Lending was often to the poor or desperate
Interest could lead to debt spirals and loss of property or freedom
So the prohibition is partly a social protection rule, not just abstract economics.
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Moral concern about commodifying money
Your statement assumes:
Money is a commodity like anything else
Islamic thought pushes back:
Money is a medium of exchange, not a productive asset by itself
Charging for its mere use, without risk or effort, is seen as unearned gain
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Modern tension, intuition vs. tradition
You’re expressing a very common modern critique:
In modern economies, capital clearly has a price
Interest helps allocate resources efficiently
Within Muslim-majority societies, there’s an ongoing debate:
Some argue interest is economically necessary and transparent
Others maintain the traditional view for ethical and religious reasons
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Why the “interest is bad” idea persists
Despite practical workarounds, the prohibition remains important because it reflects broader values:
Avoiding exploitation
Emphasizing shared risk
Linking finance to real economic activity
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Bottom line
From a modern economic lens, interest looks like a normal price.
From the Islamic legal/moral lens, interest looks like a guaranteed, risk-free gain from money alone — which is considered unjust.
That difference in starting assumptions is why the conclusions diverge so sharply.
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What are the practical workarounds used in Islamic countries to avoid interest payments while still providing credit?
Common workarounds:
1-Murabaha (markup sale)
Bank buys an asset (car, house) → sells it to you at a higher fixed price, paid over time.
This is the most common; looks very similar to a loan in practice
2-Ijarah (lease)
Bank owns the asset → you pay rent → sometimes transfer ownership at the end
3-Profit-sharing (e.g., Mudarabah / Musharakah)
Bank and borrower share profits (and sometimes losses) from a business
4-Fees instead of interest
Fixed “service” or “profit” charges structured into the contract
All of these aim to:
Avoid calling it interest, “riba”
Tie returns to sales, leases, or partnerships
But in practice, many end up:
Fixed and predictable
Economically similar to interest-based loans, just structured differently.
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“Money itself shouldn’t generate a risk-free return”
Loaning money is risk-free? What is the purpose of bond ratings?
No, lending money is not risk-free, which is exactly why systems exist to measure that risk.
Organizations like Moody's Investors Service, Standard & Poor's, and Fitch Ratings assign bond ratings to indicate the likelihood a borrower will repay its debt.
A high rating, e.g., AAA, suggests very low default risk, while lower ratings down to junk status — BB and below, signal higher risk and therefore require higher interest rates to attract investors.
Lower and higher interest rates in conventional finance exists to compensate lenders for risk, inflation, and the time value of money — one reason critics argue the “risk-free” critique of interest (in religious frameworks) doesn’t fully match modern financial reality.
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Why isn't loaning risk-free, if the borrower cannot pay off the loan can't the lender seize the borrower's assets?
Lending isn’t risk-free because collateral, e.g. the borrower’s house, rarely guarantees full recovery.
The asset’s value can fall below the loan amount, legal processes to seize it can be slow and costly, and resale often happens at a discount.
Because lenders may recover only part of what they’re owed —or face long, costly delays— there’s real uncertainty, which is why credit risk is assessed by banks and agencies and the interest rate charged is adjusted.
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the financial system
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