The Islamic Rate of Return Versus the Nominal Rate of Interest: A Macroeconometric Model

Abstract

This paper investigates the question of “will the replacement of the nominal interest rate by the expected Islamic real rate of return have positive consequences on the macroeconomic performance?” The study adopts a dynamic small-scale macroeconometric model, which describes the transmission mechanisms among macroeconomic variables under three scenarios about the Islamic real rate of return. The baseline model and the model scenarios are solved using the stochastic simulation. The results of the study indicate that scenario 1 of a zero Islamic real rate of return, or equivalently a zero real interest rate, is superior over other model scenarios, given the priority of the goal of price stability among other objectives of monetary policy.