Inflation, characterized by a sustained increase in the general price level of goods and services in an economy, tends to lessen purchasing power which can potentially destabilize economic growth. Conventional economic managing inflation requires interventions such as interest rate changes or alterations to the money supply. Some Islamic economists, however, suggest an alternative framework for inflation control based on ethical considerations, social justice, and risk sharing. This article highlights some central features of the Islamic economic system and analyzes its effectiveness in combating inflation using Malaysia as a case study.

Principles of the Islamic Economic System

The Islamic economic system is based on principles derived from the Quran and Sunnah, ensuring ethical, just, and sustainable economic practices. It prohibits Riba to promote fair financial transactions and encourages alternative financing methods like profit-sharing. Also, it encourages the giving Zakat, which serves as a mechanism for wealth redistribution, reducing economic disparities and supporting social welfare. The system also forbids uncertainty and gambling to prevent speculative and unethical transactions.

Ethical conduct is emphasized to maintain transparency, justice, and accountability in business dealings. Additionally, risk-sharing mechanisms such as Mudharabah and Musharakah encourage cooperative investment structures where both parties share in profits and losses rather than burdening one side with fixed obligations. For instance, In an Islamic bank, instead of charging interest on a business loan, the bank may enter a Musharakah (partnership) agreement with the entrepreneur, sharing both profits and losses based on agreed terms. These principles collectively aim to create a stable, equitable, and sustainable economic environment that fosters economic growth while mitigating the adverse effects of inflation.

Potential Impact on Reducing Inflation

The distinctive features of the Islamic economic system offer several potential solutions for mitigating inflation:

Asset-Backed Financing: It is a cornerstone of Islamic finance because it requires real economic activity in all financial transactions. This reduces the creation of money without corresponding increases in goods and services, a key driver of inflation in conventional systems. For instance, the main cause of inflation is the increase in the total amount of money in circulation without a corresponding increase in production level.

Discouragement of Speculation: The prohibition of uncertainty and gambling prevents certain activities that lead to speculation related to inflation and asset bubbles. The Islamic system promotes rational choices with rational thinking that inhibits markets from becoming overly optimistic.

Zakat and Wealth Redistribution: The practice of Zakat facilitates wealth redistribution which raises both the purchasing ability and consumer demand of lower-income communities while driving production at the same time. The system leads to enhanced supply and production activities that ultimately drive down price levels and decrease inflation.

Stability of the Financial System: While aiming at financial system stability, it also reduces the likelihood of excessive borrowing through riba-based instruments. This reduces the chances of creating a financial crisis which brings subsequent uncontrolled inflation.

Ethical Conduct and Trust: The emphasis on ethical conduct and fulfilling contractual obligations promotes trust and reduces transaction costs in the economy. This can lead to greater efficiency and lower prices for consumers.

Several studies have explored the macroeconomic effects of Islamic finance. Islamic banking's financing and deposits have a non-significant relationship in the short run. However, in the long run, they contribute favorably and significantly to economic growth (Gani, 2021).

Case Study: Malaysia

Malaysia can be considered a notable example for examining the potential of Islamic economics in managing inflation due to the country’s advanced Islamic finance sector simultaneously operating with a conventional system. Malaysia has made progressive efforts to promote Islamic banking, Takaful (Islamic insurance), and Sukuk (Islamic bonds). As of recent data, Malaysia hosts 16 fully-fledged Islamic banks, including five foreign institutions, with total Islamic banking assets amounting to approximately US$168.4 billion. This represents about 25% of Malaysia's total banking assets and over 10% of the world's total Islamic banking assets.

Islamic Banking in Malaysia: The Islamic banking industry in Malaysia has shown significant growth through various Shariah-compliant financial services which have become accessible to customers. The banks conduct their operations using profit-sharing methods instead of interest-based finance.

Sukuk Market: Malaysia is a global leader in the Sukuk market. Malaysian sovereign and corporate Sukuk are used to fund various infrastructure projects as well as economic activities. Sukuk, which is compliant with Shariah laws, offers an alternative to traditional bonds. They are similar to asset-backed securities.

Figure 1: Islamic Finance Vs Inflation in Malaysia 2014 - 2023

Source: Inflation Rates: WDI, Islamic Finance Growth: Statista

While Malaysia has not eliminated inflation, its experience suggests that Islamic finance plays a role in mitigating inflationary pressures. The diagram above shows that a negative relationship exists between Islamic finance growth and the inflation rate in Malaysia. Azmi and Ali (2013) indicated that inflation has a negative correlation with profitability ratios in Islamic banks in Malaysia. The asset-backed nature of Islamic finance, coupled with ethical considerations, may contribute to greater price stability compared to conventional systems.

Malaysia’s experience demonstrates that integrating Islamic finance principles can help reduce inflation by anchoring financial transactions to tangible assets and fostering risk-sharing rather than reliance on interest-based lending. Malaysia has enhanced financial stability and curtailed speculative practices that drive-up prices with the elimination of riba and promotion ethical wealth redistribution. Furthermore, robust regulatory frameworks like the Islamic Financial Services Act 2013 and the coordinated efforts of the central bank have ensured that liquidity is managed prudently, supporting sustainable economic growth while keeping inflation in check.

Conclusion

The Islamic economic system that prioritizes ethical behavior, social justice, and even risk sharing, offers a unique approach to managing inflation. To prevent excessive currency issuance and speculation which lead to inflation, the system prohibits Riba while supporting financing based on tangible assets. Zakat also contributes by redistributing wealth and increasing the demand and production of goods and services. In Malaysia, it was found that having an advanced Islamic financial system can aid in stabilizing prices. More studies are required to understand the potential of Islamic economics in addressing inflation and other macroeconomic challenges in diverse economic contexts. Additionally, a stable Islamic financial system can give the public confidence to conduct transactions and thus grow the economy.