How inflation can be controlled by using Islamic financial products

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This empirical study (Empirical studies are the collection and analysis of primary data based on direct observation or experiences in the ‘field’) provides several important findings, first, based on Granger causality test, (The Granger (1969) approach to the question of whether causes is to see how much of the current can be explained by past values of and then to see whether adding lagged values of can improve the explanation. is said to be Granger-caused by . if helps in the prediction of , or equivalently if the coefficients on the lagged ‘s are statistically significant. Note that two-way causation is frequently the case; Granger causes and Granger causes .)

Overall conventional monetary policy transmission channel show no continuity and not in accordance with the theory, as well as the transmission channel of monetary policy sharia cannot be clearly identified and disconnected in yields or profit and loss sharing deposits. Deposit yields using contract profit and loss sharing, as well as Mudaraba and Musharaka financing margin show significant negative effect on the real sector output and does not have a significant influence on the level of inflation. By this we mean that sharia instruments can be the effective instrument in reducing inflation rate and also encouraging the growth of Islamic banking. They should also consider the right margin level to increase the output on real sector. Second, the results of overall IRF (Impulse Response Function), shock, Export Import and Monetary Instrument, have interrelated impact to the inflation. It means it will increase inflation in the long run and this response is permanent. Interest rate (conventional) has negative impact and permanent to the inflation.

SBIS (Instruments of Indonesian monetary policy) – This means decrease in PLS will increase the inflation which is in line with the theory. From the result of these studies lead to the empirical conclusion that monetary policy to reduce inflation with Islamic pattern is more effective than the conventional pattern, in accordance with research by Ascarya (2012) which examined the dual monetary system through conventional credit channel and Shariah financing. The Research investigates whether domestic monetary policy reaction functions are influenced by global variables and how Islamic Monetary instrument respond on it. We estimate vector error correction model with domestic variables (domestic inflation and output gap, interest rate), with global variables(Export-Import, Exchange Rate) and Islamic Monetary instrument (Profit and Loss Sharing, SBIS), incorporating domestic and global variables in one reaction function and augmenting it with external variables such as real effective exchange rate and foreign interest rate. We computed global variables and domestic variables output gap for Indonesia and find that the global measures are not highly correlated with domestic inflation and output gap. To distinguish the output gap on the inflation the residuals obtained from this regression are used as the component of domestic inflation and output gap that is not related to the global variations. Then we estimated forward-looking policy reaction function for the Indonesia with domestic and global inflation, output gaps. Moreover, we augmented policy reaction function with foreign variables such as export-import. We find strong empirical evidence that the policy makers at the Bank Indonesia consider the international factors while conducting monetary policy.
For a sample period from 2009- 2015, we find that they respond to the global inflation, global output gap and the country specific output gap while the country specific inflation appears as insignificant. The global inflation appears as significant irrespective of the specification used to estimate the Taylor Rule In economics, a Taylor rule is a reduced form approximation of the responsiveness of the nominal interest rate, as set by the central bank, to changes in inflation, output, or other economic conditions.

In particular, the rule describes how, for each one-percent increase in inflation, the central bank tends to raise the nominal interest rate by more than one percentage point. This aspect of the rule is often called the Taylor principle. Although such rules may serve as concise, descriptive proxies for central bank policy, they are not explicitly prescriptively considered by central banks when setting nominal rates. According to Taylor’s original version of the rule, the nominal interest rate should respond to divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product (GDP) from potential GDP, where the coefficient is well above unity.

This result does not seem surprising once we consider the globalization of inflation. The literature on globalization of inflation such as studies by Ciccarelli and Mojon (2010), Bagliano and Morana (2009) among many others show that larger variance of domestic inflation rates is explained by international factors. Similar results were obtained when we estimated reaction function using the inflation measure based on CPI. However, contrary to the full sample estimation in sub sample estimation of the reaction function (1992-2010 for the United Kingdom and for 1987-2010 for the United States) we find that the country specific inflation as well as global inflation is taken into account while setting the monetary policy rate.

Another important result of the research is, we find that Bank Indonesia is more concerned about the medium and long term variation in inflation and does not follow the Taylor principle when responding very short term variation in inflation. Moreover, we find evidence that the Bank Indonesia respond to changes in real effective exchange rate.

However indonesian experience tells that three issues needs to be resolved for develoing monetray policy for Islamic finance (1) the transferability of financial participation in the capital market without any acknowledgement of the other parties (2) the permissability of claim trading in secodary market (3) permissibility of securitization of the assets of Islaimc institutions.

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