Lecture 1: Introduction to the Applied Islamic Economics

The proposal of “Applied Islamic Economics” is innovative and aligns well with ongoing discussions in Islamic economics. It combines theoretical foundations with empirical analysis. By incorporating real-world case studies and modeling interest-free scenarios, this framework can provide a robust argument for the feasibility of a welfare state under Islamic principles.

Feasibility of Constructing an Islamic Economic System

• Principles: Islamic economics emphasizes welfare for all, ethical considerations, and the prohibition of interest (riba). It promotes risk-sharing, equitable distribution, and the integration of moral values in economic transactions.
• Case Studies: Analyzing real-world scenarios under an interest-based economy is straightforward due to abundant data. For an interest-free economy, while fewer examples exist, simulations and assumptions (e.g., dummy variables) can be used to model outcomes.

Brief Introduction to Applied Islamic Economics

We propose analyzing two scenarios:

1. Interest-Based Economy:
   • Factors such as interest rates, employment, inflation, and others impact GDP.
   • Reflects a conventional economic model with tangible and intangible variables.
2. Interest-Free Economy:
   • Assumes zakat replaces interest as a redistributive tool.
   • Focuses on welfare for all, emphasizing ethical growth, equitable distribution, and introducing moral values.

Key Considerations for Feasibility

1. Modeling Real GDP:
   • Interest-Based Formula: Real GDP=f (Interest Rate, Employment Rate, Inflation, Literacy Rate, Real Assets Growth, Social Welfare, Crime Ratio, Moral Values, State Tax Rate)
   • Interest-Free Formula: Real GDP= f (Zakat, Employment Rate, Inflation, Literacy Rate, Islamic Taxes, Real Assets Growth, Welfare for All)
2. Case Studies and Data:
   • Interest-based economies have significant data availability.
   • Interest-free economies like Pakistan’s zakat system or Islamic banking models in Malaysia can provide valuable insights.
3. Hypothetical Models with Dummy Variables:
   • When real-world examples are absent, use a dummy variable (e.g., setting interest rate = 0) to simulate interest-free scenarios.
4. COVID-19 Pandemic Case Studies:
   • Analyze how different regions implemented welfare measures during the pandemic.
   • Assess whether the principles of Islamic economics (e.g., charity, solidarity) were informally adopted.
5. Ethical and Moral Dimensions:
   • Measure “moral values” and “social welfare” through proxies like crime rates, trust indices, and equitable access to resources.

Challenges

• Data Collection: Limited data on large-scale Islamic economies.
• Quantifying Moral Variables: Factors like “moral values” and “welfare for all” are subjective and hard to quantify.
• Acceptance of Assumptions: Using dummy variables or hypothetical constructs may face academic scrutiny.

Interest-Free Economy Through E-Views

Introducing a dummy variable to simulate an interest-free economy in E-Views can provide meaningful insights, even if real-world case studies are unavailable. Here’s how you can incorporate the zero dummy variable, interpret its effects, and analyze the outcomes:

Incorporating a Dummy Variable for an Interest-Free Economy

A dummy variable represents a binary condition (e.g., interest-based = 1, interest-free = 0). Here’s how to use it in EViews:

Steps in EViews

1. Incorporate Data:
   • Include historical data for Real GDP, interest rate, employment, and other variables.
   • Add the dummy variable column (D) to your dataset.
2. Set Interest Rate to Zero:
   • For the interest-free scenario, replace interest rate values with zero where D=0.
3. Run Regression:
   • Use the modified Real GDP equation with the dummy variable: ls RealGDP c InterestRate EmploymentRate Inflation LiteracyRate Dummy
4. Compare Results:
   • Estimate the model for both scenarios (D=1 and D=0).
   • Analyze how the coefficients and significance levels change.

Interpretation

1. Coefficient of Dummy Variable (δ):
   • Measures the difference in Real GDP under the interest-free economy.
   • A significant negative δ(delta) suggests the economy might struggle without interest. A significant positive δ indicates the interest-free model could boost GDP.
2. Impact on Interest Rate (β1​):
   • Setting the interest rate to zero allows us to study the economy without interest.
   • If β1​ is small or insignificant in the interest-based scenario, the transition to interest-free might have minimal economic disruption.
3. Alternative Variables:
   • Analyze if other variables (e.g., zakat, Islamic taxes) gain more explanatory power in the absence of interest.
4. Scenario Comparison:
   • Use in-sample forecasts or simulations to compare GDP growth under both scenarios.
   • Evaluate the contribution of moral and welfare variables.

Challenges in Interpretation

1. Abrupt Change:
   • In reality, setting the interest rate to zero abruptly (as in Pakistan) could disrupt financial markets.
   • Dummy-based analysis assumes no sudden shock or adaptation cost.
2. Assumption of Perfect Substitution:
   • Assumes zakat or Islamic taxes will seamlessly replace interest-based mechanisms. Real-world implementation may differ.
3. Policy Implications:
   • Results must consider broader systemic effects, such as liquidity constraints and investor confidence.

Concluding Insights

Using a dummy variable to simulate an interest-free economy in E-Views is a valid approach to test hypotheses. However, the interpretation must account for practical challenges and policy nuances. This analysis can reveal whether an interest-free economy could sustain or enhance growth and welfare under Islamic principles.