Inefficiencies in Search Models: The Case for Islamic Finance

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.