No abstract

The potential effect of financial variables on the level of investment is among the key issues in contemporary financial economics. Some researchers have claimed that there is an inherent risk in the Islamic profit‐and‐loss sharing scheme that replaces the western fixed‐interest rate system. This paper argues that such concerns are baseless. In an Islamic framework, equity capital (i.e., strong financial position) and the profit‐sharing ratio are primary determinants of investment. It is shown that both factors could enhance the firm's business reputation and its investment activities. The paper, in so doing, constructs a two‐period equilibrium model of profit‐sharing contracts. An optimal solution for the investment function is derived for the banking firm. Besides equity capital and the profit‐sharing ratio, other relevant determinants of investment are also considered, including depreciation and expected inflation. Moreover, unlike most previous research in this area, the resultant investment (and profitsharing ratio) functions are subjected to empirical testing using data from a representative Islamic bank.

Constructs a simple neoclassical growth model in which financial factors play an important role. The model demonstrates that the injunction against fixed interest payments induces the monetary authority in the Islamic economy to develop and innovate alternative financial instruments that do not have fixed nominal values and do not bear predetermined rates of return. The model also proves that financial innovation is welfare enhancing, while inflation reduces welfare and hampers growth. The model further proves that the government in an Islamic economy can effectively coordinate its fiscal and monetary policies to finance the budget using the Zakat and seigniorage.