Is optimal Islamic financial contract stabilizing? The perspective of a New Keynesian model with the financial accelerator

This paper aims to inspect the stabilization aspects of Islamic financial contracts by drawing on a New Keynesian macroeconomic model with the financial accelerator. The model allows for shared responsibilities on both the assets and liabilities sides of the Islamic banks that resemble, in principle, the two-tiered Mudarabah financing on the asset side and profit-sharing investment accounts on the liability side. The implied optimal Islamic financial contract argues that payoff distribution between entrepreneur and bank is contingent on the macroeconomic environment via the entrepreneur's leverage, whereas that between bank and investors is endogenous to bank's capital and leverage. Compared to the conventional debt contract with a predetermined return, we find that an Islamic financial contract amplifies shocks as much as conventional financial contracts do, if not to a greater extent. The impacts on entrepreneurs' and banks' leverage, however, depend largely on the source of the shock and are opposite to those observed under conventional debt contract. Whereas favorable aggregate supply and monetary shocks increase the overall leverage, shocks favorably hitting preference and marginal efficiency of investment reduce the leverage. The underlying mechanism is the shock-shifting ex post payoff distribution between creditors and debtors that shapes the cost of the external finance and, thus, leverage.