Category Archives: Traditional Economic Theories

Interest, its meaning, definition and context of use

Following is a comprehensive understanding of interest, from an email message posted by Mark Robbani of the Institute of Islamic Finance, on the IBF-NET YahooGroup. 


Regarding the meaning of the word ‘interest’: It would be better to define the context of its use first, before discussing its meaning. Putting aside the true linguistic origins of the word, since ‘interest’ is currently an English word, then for our purposes – we should really use the English meaning of it only in financial & economic contexts. Thus:  

[from: http://en.wikipedia.org/wiki/Interest%5D

In finance, interest has three general definitions.

Interest is a surcharge on the repayment of debt (borrowed money).

Interest is the return derived from an investment.

Interest is the right to one’s claim in a corporation, such as that of an owner or creditor.

In economics, interest is the return to capital achieved over time or as the result of an event. In population dynamics the rate of population growth (the interest rate) is sometimes referred to as the Malthusian parameter. This article covers the “financial” use of the term.

[from: www.investorwords.com/2531/interest.html]

Definition 1

The fee charged by a lender to a borrower for the use of borrowed money, usually expressed as an annual percentage of the principal; the rate is dependent upon the time value of money, the credit risk of the borrower, and the inflation rate. Here, interest per year divided by principal amount, expressed as a percentage. also called interest rate.

Definition 2

The return earned on an investment.

Definition 3

Partial or total ownership in an asset.

[from: http://en.wikipedia.org/wiki/Interest%5D

In common use the term “interest” is seen as rent paid for the use of money. As with any rental, the market price (or rate) is subject to change to reflect market conditions. The fraction by which the balances grow is called the interest rate. The original balance is called the principal. Interest rates are very closely watched indicators of a financial market, and have a dramatic effect on finance and economics.

The fact that lenders demand interest for loans can be attributed to the following reasons:

Time value of money or time preference

(TVM: Having money now is more valuable than having it at some future time because interest is earned)

(TP: Interest is the value borrowers place on having money now)

Opportunity cost

(OC: The cost in terms of options no longer available once one particular option is chosen)

We should narrow down the use of the generic term ‘interest’ to the more specific ‘interest rate’ and also accept the practical application of ‘interest rates’ as the Central banks of the English speaking and western European countries apply it. Thus:

[from: http://en.wikipedia.org/wiki/Interest_rate%5D

An interest rate is the price a borrower pays for the use of money he does not own, and the return a lender receives for deferring his consumption, by lending to the borrower. Interest rates are normally expressed as a percentage over the period of one year. Interest rates are also a vital tool of monetary policy and are used to control variables like investment, inflation, and unemployment.

For instance:[from: http://www.bankofengland.co.uk/monetarypolicy/how.htm]

[from: ]The Bank of England sets an interest rate at which it lends to financial institutions. This interest rate then affects the whole range of interest rates set by commercial banks, building societies and other institutions for their own savers and borrowers. It also tends to affect the price of financial assets, such as bonds and shares, and the exchange rate, which affect consumer and business demand in a variety of ways. Lowering or raising interest rates affects spending in the economy.

Thus, the meaning & definition of interest appropriate for our purposes is the one ‘in common use’ – which happens to be a “surcharge on the repayment of debt (borrowed money)”, “rent paid for the use of money”, “The fee charged by a lender to a borrower for the use of borrowed money”, etc. All of these definitions are actually for the more relevant and specific term, ‘interest rate’ – and are similar to my own definition, which is a monetary charge applied for the use of money).

Here, the surcharge, rent or fee is actually money, which is exchanged for more money (i.e with a contractual difference in the corresponding/counter values). Since any contractual difference in the value of 2 or more items of the same type, quality and value when they are exchanged (irrespective of the time-period involved or the type, magnitude or form of the difference) is Riba, it therefore follows that the surcharge, rent or fee (in this context) is also riba [as any such surcharge, rent or fee (i.e monetary charge) is an ‘increase’ or an ‘excess’ in a like-for-like (money-for-money exchange) – thus haraam].

Regarding the variations in the application and meaning of the word ‘interest’ in different countries & languages: This is really more to do with sociology rather then the financial sciences. This is really more to do with sociology rather then the financial sciences.

For instance:

Although in the German language “…jurists categorise rent as being interest (while rent is not riba, and in Dutch interest is event called rent) and accountants sometimes go as far as talking about interest on equity (which will finally confuse everybody to mix up profit with interest)…” – when the German and Dutch (and most other) central banks set the base interest rate, they set it as their monetary charge for lending to financial institutions, and not as the base property/asset rental amount, or equity dividend, etc. This alone should make clear the true meaning of interest (and the context of its use) for our purposes. All other meanings are culturally subjective and thus not suitable for our universal & legalistic use.

Although in the German language – when the German and Dutch (and most other) central banks set the base interest rate, they set it as their for lending to financial institutions, and not as the base property/asset rental amount, or equity dividend, etc. This alone should make clear the true meaning of interest (and the context of its use) for our purposes. All other meanings are culturally subjective and thus not suitable for our use.

In conclusion:

My own personal opinion still remains that ‘interest’ (the form in common English and use) and more specifically, ‘interest rates’ riba (as defined by the authentic sources), but riba (again, as defined by the authentic sources) is not restricted to ‘interest’.

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Filed under Basics and Definitions, Traditional Economic Theories

Definition of Money

Most of the economists will define money by its four classical functions:

  1. Means of exchange;
  2. Measure of value;
  3. Medium of deferred value; and
  4. Store of value.

We will go over a brief explanation of each of these functions of money and how it relates to Islamic economics. Specifically, we will discuss some of the deficiencies of money (i.e., fiat money) in light of these functions. Ultimately, the fundamental question we wish to answer is whether money is a commodity.

Source: Abu Saud, Mahmud. “Money, Interest and Qirad.” Studies in Islamic Economics. Ed. Khurshid Ahmad. Leicester: The Islamic Foundation, 1980. 59.

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Filed under Money, Traditional Economic Theories