Islamic banking financing and inflation: Empirical evidence from dual banking systems

Abstract

The rapid growth of Islamic finance, especially within the sector of Islamic banking, has attracted significant attention from scholars, policymakers, and financial practitioners alike. This surge has prompted various discussions about how Islamic finance influences the broader economy. This study aims to provide a comprehensive analysis of the impact of Islamic bank financing on inflation rates across twelve countries operating dual banking systems, from 2013 to 2022. The research employs advanced statistical techniques, specifically Fully Modified Ordinary Least Squares (FMOLS), combined with fixed effects methods to ensure a thorough analysis of the data. The FMOLS approach is particularly effective in correcting potential endogeneity and serial correlation, enabling more accurate estimation of long-term relationships between the variables under study. Meanwhile, the fixed effects technique controls for unobserved heterogeneity by accounting for individual-specific effects, thus isolating the impact of the independent variables on the dependent variable. The study's findings reveal that Islamic financing does not significantly affect inflation rates in the countries examined. The research suggests that the expansion of Islamic banking does not contribute to inflationary pressures. Furthermore, it emphasizes that interest-free funding has the potential to serve as a stabilizing force within the economic system.