IMPACT OF INFLATION ON ISLAMIC FINANCING: EMPIRICAL EVIDENCE FROM MALAYSIA

Predictable increases in inflation can severely damage the financial sector by hindering its ability to finance capital formation. Recent studies provide evidence regarding the importance of the financial sector in reducing information asymmetries and illustrate that high inflation rates lead to an increase in credit market frictions with negative effects on the financial sector. In particular, these theories highlight the fact that an increasing rate of inflation lowers the real return on money and assets, which in turn leads to a reduction in savings and squeezes the credit markets, which exacerbates credit market frictions, resulting in a reduction in credit availability in the economy. Existing theoretical models also suggest that there exists an acceptable threshold for the inflation rate and once this threshold is exceeded, it exacerbates credit market fictions and leads to credit rationing. In the case of Islamic banks, this relationship is yet to be examined.