The costs of money creation in orthodox banking system and Islamic finance solution

Abstract

The performance of the fractional-reserve banking system, will lead to a vast money creation in favor of banks. This results in inflationary problems. This type of banking system will also lead to some issues like the transfer of borrowers’ risks to banks and sometimes to depositors, monetary and banking crises, free ridings, adverse selection and moral hazard, and etc. In this research, the cost of money creation is determined by two scenarios. The first scenario is money creation in a fractional-reserve banking system, and the other is central bank’s money creation with requirement reserve of 100 %. Then the social loss function related to money creation is defined. The results of minimizing social loss function with the constraints of Philips curve and aggregate demand function show that the instability and social loss will increase with reduction of the reserve requirement. In other words, policy makers can reduce social costs and instability of economy through the expansion in the reserve requirement.

Keywords

• conventional banking
• fractional reserve system
• money creation
• reserve requirements
• social loss function
• dynamic programming
• instability