Monetary Policy Transmission and Its Implications for Islamic Banking: Challenges and Shariah-Compliant Alternatives

Abstract

Monetary policy is on of the important factors of macroeconomic management, aiming to achieve monetary stability and promote economic growth by controlling the money supply and credit. It has undergone significant evolution throughout history, moving from traditional tools based on interest and discount rates to more complex modern instruments such as unconventional open market operations, quantitative and qualitative easing, and large-scale liquidity management. This evolution has lead to fundamental challenges to Islamic banking, which is based on Sharia principles that reject interest (riba) and emphasize its connection to the real economy. This research analyzes the impact of conventional monetary policy on Islamic financial institutions. The research highlights the channels through which monetary policy is transmitted to Islamic banking. The research also discusses the liquidity management channel and the challenges it presents due to the scarcity of Sharia-compliant instruments, as well as the credit demand channel and its susceptibility to changes in overall monetary policy. The research also focuses on the impact of conventional interest rate adjustments on Islamic finance, despite Islamic banks not dealing directly with interest. It also examines the impact of money supply and its fluctuations on the performance of Islamic financial institutions, their susceptibility to conventional discount rates and exchange rates, and the implications of these factors for Islamic finance, particularly in open economies. In response to these challenges, the research discusses the concept of Sharia-compliant monetary policy instruments as a viable alternative capable of achieving monetary policy objectives without compromising Sharia principles. Furthermore, it underscores the importance of developing a diverse range of Islamic financial instruments to enhance the efficiency of Islamic monetary policy and support financial inclusion by expanding access to equitable and sustainable finance. The research concludes with a number of key findings, most notably that continued indirect reliance on conventional monetary policy tools limits the independence of Islamic banking, and that developing a comprehensive Sharia-compliant monetary policy framework is a strategic necessity for enhancing financial stability and achieving inclusive economic development in economies that rely on Islamic finance.