Inefficiencies in Search Models: The Case for Islamic Finance

Mabid Al-Jarhi

MPRA Paper from University Library of Munich, Germany

Abstract: In economies without friction, where money as a means of exchange has no role, the existence of the rate of interest would have no efficiency consequence. Once a friction that justifies the use of a means of exchange is introduced in the macroeconomic model, the inefficiencies resulting from the presence of the rate of interest become exposed. In search models, where money has a raison d’être, the use of money in trade when accompanied with conventional finance, is associated with two important inefficiencies. The first is the Friedman-Samuelson inefficiency. The payment of a positive (interest) rate of return on money, with guaranteed principle and return, motivates agents to economize on the use of cash in transactions. This reduces the volume of transactions below optimum. The substitution of real resources for cash would further reduce output. The second is Hosios inefficiency which results from the existence of externalities in search activities by agents. Failure to internalize such externalities would also reduce the volume of transactions below optimum. The paper argues that the switch to Islamic finance removes both inefficiencies.

Keywords: search models; Samuelson-Friedman inefficiency; Hosios inefficiency; synchronization of wants; International Financial Crisis; conventional finance; interest rate; islamic finance. (search for similar items in EconPapers)
JEL-codes: E4 E42 E43 (search for similar items in EconPapers)
Date: 2017-04, Revised 2017-10-19
New Economics Papers: this item is included in nep-dge and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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