Islamic Capital Markets: Theory and Practice

Chapter 17

Capital Markets and the Macroeconomy

This chapter addresses the interaction between capital markets and the macroeconomy. A financial crisis undermines economic growth and triggers mass unemployment. Inversely, easy money policy of the central bank, in the form of low or negative interest rates and massive liquidity, sends the stock markets into euphoria and bubbles. Throughout the past two centuries, economies with advanced capital markets were evolving through frequent cycles of booms and financial crises. Each crisis erodes past gains in per-capita income and causes widespread bankruptcies. Minsky (1986) considered the conventional financial sector to be inherently unstable and doomed to experience booms and crashes. The Great Depression was enduring for many countries. The recent financial crisis of 2007–2008 demonstrated the cost of financial crisis in terms of trillions of dollars in bailouts, enduring unemployment, and falling real per capita income. Yet, the central bank, in spite of damage caused by its money policy, never renounces the same policies that brought about the financial chaos. It tries to pull the economy out of depression through near-zero interest rates and monumental liquidity. This causes the depression to linger for a decade or more.

The policy debate on how to bring back the economy to recovery remains unsettled ever since it began in the early nineteenth century in the wake of recurrent financial crises. This chapter reviews the macroeconomic ...