Replacing the interest rate mechanism in monetary policy: case of Malaysia

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The current macroeconomic policies in Malaysia follow conventional model based on the risk-transfer and/or risk-shifting paradigm, as opposed to risk-sharing principles proposed in Islamic finance. Malaysia’s monetary policy relies and operates through short-term interest rates which is currently called the overnight policy rate (OPR) to achieve price stability. In order to become a global leader and an indisputable global hub for Islamic finance, there is a need to develop an alternative monetary policy framework for Malaysia that is Shariahbased. One of the key elements in doing so is to come up with an alternative Islamic Pricing Benchmark (IPB) that is free from interest rates. Here, we consider using equity risk premium, which is an important concept in promoting risk-sharing through equity participation. This paper aims to investigate whether equity premium could be an incentive structure for adopting Shariah-based monetary policy. After calculating the historical equity premium in Malaysia in the 1980-2011 period, the data is used to simulate the proposed monetary framework and compared with the results of the present conventional policy framework. We conclude that equity risk premium is not statistically significant as a proxy to be used in Islamic monetary policy framework in Malaysia. However, we propose Return on Equity (ROE) as a better alternative to replace the interest rate.
Equity premium , Real rate of return , Monetary policy
Mat Sari, Norhanim, Mirakhor, Abbas & Mohd Subky, Khairul Hafidzi. (2017, February 11-13). Replacing the interest rate mechanism in monetary policy: case of Malaysia. Paper presented at 1st international Colloquium on Islamic Banking and Islamic finance, Tarbiat Modares University, Tehran, Iran.

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