Money Demand in an Interest Free Economy

The objective of this study is to derive a money demand function compatible with the Islamic Economic Rules, i.e., Prohibition of Reba. This rule, evidently eliminates the loan market from the economy.Therefore, we propose that the Islamic financial markets could link the real and nominal sectors of the economy and provide the information needed by both the financial intermediaries and the Central Bank authorities to allocate financial and liquid assets, respectively. Meanwhile, the nature of speculative activities are discussed. and conditions that facilitate harmful speculative activities are identified and the policies that are required to eliminate those conditions are proposed. Based on this financial market model, both demand for and supply of financial resources as well as demand for money balances are derived. This demand for money balance is formulated as a function of rate of return of shares exchanged in the stock market, real GDP, and inflation rate. The estimation result of this function using the cointegrated maximum likelihood Johanson-Josilious method shows that the demand for money is a stable and significant function of the above mentioned variables. Specifically, the logarithm of the money demanded (m1) is a significant and negative function of dividend’s rate of return, but positive and significant function of real GDP and inflation rate.