STABILITY OF MONEY DEMAND UNDER INTEREST‐FREE VERSUS INTEREST‐BASED BANKING SYSTEM

This study examines empirically the stability of the demand for money under two different financial systems. One system pays interest on money deposited at the bank and charges interest on bank loans; the other does not pay interest on money deposited in the bank, and enters into a profit‐sharing contract with the bank borrower instead of charging interest on bank loans. The first system resembles the western financial system and the second resembles the Islamic financial system. A study by Darrat (1988) studies the behavior of demand for money in Tunisia, and concluded that interest‐free money is more stable than the interest‐bearing money. The behavior of demand for money in fifteen countries has been analyzed in this research in order to find out if the findings by Darrat (1988) are applicable to other countries that practice Islamic banking. This study finds that the velocity of money and its variance are lower for interest‐ free banking system than for interest‐bearing banking system. This result may support the hypothesis that interest‐free money is more stable than interest‐bearing money. The monetary policy implications of interest‐free banking are also analyzed.