Monetary Management in an Islamic Economy Muhammad Umer Chapra

Written By Dinda Revolusi on Rabu, 06 April 2011 | 18.04

The monetary system that prevails in the world now has-come-into-existence-after passing.through several-stages-of evolution. The monetary system that prevailed during the Prophet’s (pbuh) days was essentially a bimetallic standard with gold and silver coins (dinars and dirhams) circulating simultaneously. The ratio that prevailed between the two coins at that time was 1:10. This ratio seems to have remained generally stable throughout the period of the first four caliphs. Such stability did not, however, persist continually. The two metals faced different supply and demand conditions which tended to destabilize their relative prices. For example, in the second half of the Umayyad period (41/662-132/750) the ratio reached 1:12, while in the Abbasid period (132/750-656/1258), it reached 1:15 or less.

In addition to this continued long-term decline in the ratio, the rate of exchange between the dinar and the dirham fluctuated widely at different times and in different parts of the then Muslim world. The ratio at times declined to as low as 1:35, and even 1:50. According to both al-Maqrizi (d. 845/1442) and his contemporary al-Asadi (d. after 854/1450), this instability enabled bad coins to drive good coins out of circulation, a phenomenon which became referred to in the 16th century as Gresham’s Law.

When the United States adopted bimetallism in 1792, the gold-silver price ratio was 1:15. However, the fluctuating prices of both metals led the US to demonetize silver in 1873. Experience of several other countries suggests that bimetallism was a fragile standard. There was no dependable way to tie together full-bodied gold and silver coins at fixed rates. This was the main cause of its universal demise.

Monometallism hence took its place. In the beginning, silver and gold both com¬peted, but silver continued to lose ground and the gold standard became prevalent around the world. It emerged as a true international standard by 1880 following the switch by a majority of countries from bimetallism and silver monometallism to gold as the basis of their currencies. Under this standard, the value of a country’s currency is legally defined as a fixed weight of gold, and the monetary authority is under an obligation to convert the domestic currency on demand into gold at the legally prescribed rate. Historically there have been three variants of the gold standard: the gold coin standard, when gold coins were in active circulation; the gold bullion standard, when gold coins were not in circulation but the monetary authority undertook to sell gold bullion against the local currency at the official rate; and the gold exchange standard  (or the Bretton Woods system), when the monetary authority was required to exchange domestic currency for US dollars which could be converted into gold at a fixed parity.
The UK was on a gold coin standard until 1914 and then a gold bullion standard from 1925 to 1932. The rules of the gold standard required deficit countries to deflate and the surplus countries to reflate their economies. This seemed unrealistic during the Great Depression when the deficit countries had no alternative but to reflate their economies to reduce unemployment. The United States and France, the two major surplus countries, also did not find it practical to follow the rules of the game. Instead of reflating their economies, they persistently sterilized their balance of payments surpluses, thus accentuating the deflationary pressure on the deficit countries. Such policies undermined the effective operation of the gold standard and it was abandoned after the Great Depression.

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