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The thesis will not be proper without discussing the relationship between financial institutions as the intermediaries in the financial market and the use of money as the medium of transactions in facilitating and prospering the economic activities. Therefore, this particular section explores the relationship of financial intermediaries, money market, and the economic activities.

Comprehensive academic discussions on the relationship between the economic activities with money and financial institutions have already existed since the beginning of the 20th century. Literature on the role of money and financial intermediaries, banks in particular, has existed since the period of ‘classical economist’ as the mainstream

economics school of thought from roughly 1775 to 1930. Adam Smith through his writing in 1776 recognised the importance of money and financial intermediary roles that could make the economy grow. The most influential writing of the ‘Classical Economist’ on the relationship of money with the economy will be the Fisher’s ‘Quantity Theory of Money’ (Fisher, 1911).

Currently there are three well-known competing hypotheses concerning the influence of money in business cycle phenomena. They are the traditional monetarists, real business cycle economists, and new classical economists. The traditional monetarists lead by Brunner and Meltzer (1993) as Keynesians claim that changes in the money supply will affect the production activities for the reasons of sticky prices and wages. Real business cycle economists on the other hand believe that changes in the money supply have no significant effects on real output (King and Plosser, 1984). Whilst Lucas (1973 and 1975) on the new classical economists, conjecture that changes in the money supply affect output only as much as they induce producers to deviate from their plans.

Literature on money from Islamic scholars on the other hand, is traceable even before the era of ‘classical economists’. Conventional Muslims’ scholars gave discussants on the concepts and role of money. Ahmad ibn Hambal (d. 23/644) was among the earlier scholars discussed the concepts of money. He concluded that anything that generally accepted by the people could be adopted as currency. Ibn Hazim (d 456/1064) in his discussion on the concepts of money did not find any reason for the Muslims to confine their currency to gold and silver only. The dirham and dinar according to Ibn Taymiyyah (d 505/1328) were not desired for their own sake but rather because of their ability to serve as media of exchange (Chapra, 1996). These early views on the role of money and literature contributed by the Islamic scholars, however, went missing after the collapse of the Muslims empire.

From the Islamic view, money is simply a potential capital and not considered as capital (Akacem and Gillian, 2002). Thus, to get a return to holding money requires the services of other economic agents such as firms or the producers for instance, to transform it into a more productive use. Hence, transforming money into a productive use and undertaking a risk is necessary to justify for any return out of it. In an interest- based banking system, converting money into capital or by using it productively has nothing to do with the depositors. From the shariah view, obtaining a return to money placed in a bank of no transforming it into a productive use is definitely unacceptable. Furthermore, even though the depositors’ money is transformed into any productive and risky used no fixed returns to the depositors can be set regardless of the profits.

2.2.1 Contemporary Views on Money, Credit, and Banking

Today’s households and firms rely heavily on debt to finance the consumption expenditure spending and working capital expenses. In most cases, the internally generated funds are not enough to finance the households consumption spending and firms investment spending for any additional assets. Therefore, the economic agents will have to consider the external sources of funds to cover the deficit. Households represent the ultimate source of funds of the economic agents with most of the loans is channelled through the financial intermediaries, particularly banking institutions.

With the advancement in modern economic activity and with it becomes very much complicated, bring to the needs for the existence of modern financial intermediaries to facilitate and support the growing economic activities. Without the financial intermediary active participation, the banking system in particular, the progress of economic growth is inconceivable. The economy will grow faster with financial intermediation deepening or more advance, active, and develop financial intermediation system. The existing of these highly advanced and sophisticated credit facilities,

however, can create a serious mismatch of aggregate supply and demand that will bring to a severe fluctuation of the economic activity.

An economist by the name of Schumpeter (1911) explained the role of financial intermediaries in spurring innovations and growth by identifying and funding productive investment. According to his theory, the role of financial intermediaries acts on behalf of the society in general to satisfy the demand for credit by entrepreneurs’ selection of firms that are regarded as worthies of obtaining the loans. It also assesses the firms’ risks and evaluates the borrowers’ creditworthiness.

Following the famous Keynes’ “General Theory of Employment, Interest, and Money (1936) and the monetarist theory (1960s), the early consideration brought by the classical economists on the important role of the credit markets was largely forgotten and ignored. It was until 1970’s, the literature and foundations being redeveloped that conjecture the important role of the credit market. The idea embarks upon the recognition of the presence of asymmetric information issue caused by the imperfect market and imperfect information phenomenon.

New theoretical foundation and empirical work developments started to revive the concerns on the bank’s lending role in the business cycle phenomenon after the beginnings of Frediric S. Mishkin’s empirical work in 1978 involving reconsideration on the part of financial markets and institutions role in the Great Depression episode. Analysing the data onto a more sophisticated statistical method, Mishkin (1978) determines whether the financial factors have an effect on consumer spending in the event of the Great Depression. The study shows the households’ net financial positions significantly determined the consumer demand. With the deflation condition and declining incomes, the consumer real indebtedness also increased. This observable fact

has driven the consumers to reduce their spending in the economy. This scenario consecutively magnifies the recession and further deteriorates the economic depression phenomenon.

Bernanke (1983) analysed further on the significance of monetary variables relatively against the financial aspects in the event of the Great Depression. One important determinant of the depression’s intensity was the collapse of the financial system. The extensive number of debtors’ insolvency and the loss of faith with the financial institutions, particularly the commercial banks are the two major gears that collapsed the financial system of that undesirable economic event.

The view raised by Bernanke’s (1983) is that, the 1930-33 market disturbances had disrupted the financial market effectiveness in performing the nontrivial market making and inflation gathering services. As markets for financial claims were imperfect, intermediation between lenders and borrowers needed those services. In that economic events, some borrowers found that the credit facilities had become so expensive and difficult to obtain as the real costs of intermediation had increased. The impact on the aggregate demand of this credit squeeze had contributed to the turning of severe economic downturns of 1929-30 to an extended economic depression.

Mishkin (1978) and Bernanke (1983) analyses provide support on the significance of the debt-deflation theory brought by Fisher’s (1933). The results of their studies prove that the condition of financial markets has a role in propagating the Great Depression event in particular and the business cycle phenomenon in general.

Following the historical fact after a long absent, literature on significant relationship between economic growths and efficient financial markets actually arose in 1950’s. It

began with the publication of writing by John Gurley and Edward Stone Shaw that is the “Financial Aspects of Economic Development” in 1955. Gurley’s and Shaw’s (1955) writing emphasis on the financial intermediation function in credit creation processes. The financial intermediation deepening and a very much-organised financial system exist in the developed countries. They argue that the economic development is hindered if merely self-finance and direct finance are accessible and financial intermediaries are not involved. Thus, the existence of financial intermediaries improves the efficiency of intertemporal trade, which is an important factor that governs the smooth running of the economic activities.