Purpose: This paper aims to investigate the macroeconomic effects of Qard-al-Hasan (QH) as a tool of monetary policy (MP) and its effectiveness in achieving full employment and price stability in the economy. Design/methodology/approach: QH-based MP and its effects on major macroeconomic variables are examined on theoretical ground by using the standard aggregate output and aggregate expenditure model within the framework of Islamic economic principles. Findings: QH-based MP positively influences real sectors of the economy and increases output, and the economy returns to full employment. QH provides the lowest possible borrowing costs across the economy and thus triggers rightward shift in aggregate supply curve and thus increases output and lowers price level. In addition, increase in output eliminates excess demand or shortages and thus maintains price stability. Furthermore, QH-based MP also increases exportable surplus and exports, decreases imports as well as increases inflow of funds and foreign currency reserves with the Central Bank and thus makes MP more effective. Research limitations/implications: QH-based MP is usually expansionary MP, and as such, it can be argued that there is a probability that QH-based MP may lead to higher inflation rate. However, in this study, it has been shown with real world data in Table II, that 23 countries in Group 1 have pursued zero or negative interest rate policy and their experiences mitigate such probability. Originality/value: This is, perhaps, the first paper that presents a complete model of QH as a tool of MP with fully explained transmission mechanism. This is new contribution in the literature of Islamic finance where theoretical model on QH is systematically developed and applied as an effective tool of MP in attaining full employment and price stability. This model of QH-based MP can unfold a new horizon of uninterrupted economic growth, full employment and price stability by increasing output and employment, as well as by eliminating excess demand or shortages. © 2018, Emerald Publishing Limited.

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