The effect of an interest-free banking system on level and volatility of inflation: a GARCH model

Abstract

Some Muslim researchers argue that a no-interest financial system better achieves the goal of price stability. Using a GARCH model, this article examines the effect of an interest-free banking system on level and volatility of inflation in a country with a full-fledged no-interest financial system. Iran is chosen for our case study because it has initiated the most far-reaching experiments with interest-free banking in the Muslim world. The results indicate that the new financial setting in Iran has reduced inflation uncertainty but has failed to lower the level of inflation.

Notes

¹ Darrat (2002, p. 747).

² For example, see Chapra (1985) and Darrat (1988).

³ Iran and Pakistan have restructured their whole banking system in accord with Islamic principles. For more detail on Islamic banking in Iran and Pakistan, see Khan and Mirakhor (1990).

⁴ Seminal works of Friedman (1977) and Cukierman and Meltzer (1986) form the bases for many empirical researches on inflation-uncertainty relationship. For example see Darrat and Lopez (1988), Evans (1991), Grier and Perry (1998), and Kontonikas (2004).

⁵ Exchange rate unification policy of 1994–1996 attempted to narrow the gap between black market and official exchange rates in Iran. However, it failed to achieve its goal and hence was abandoned by the Iranian government.

⁶ In order to use a GARCH process it is quite important not to have an autocorrelation problem in our model.