Working Paper in Islamic Economics and Finance No. 1006 Tools in Controlling Monetary Variables in Islamic Banking System Abdul Ghafar Ismail 1 International Shari’ah Research Academy for Islamic Finance and Research Center for Islamic Economics and Finance Universiti Kebangsaan Malaysia Bangi, 43600 Selangor D.E., Malaysia Fax: +603-8921 5789 e-mail: agibab@ukm.my Abstract The prohibition from receiving and paying interest in Islamic banking system raises the question on how the monetary policy would be conducted in the absence of interest, both as a tool of monetary policy and also the choice of monetary variables to be controlled. In addition, the Islamic banking system is designed on the principle of profit sharing or non-profit sharing. In the first model, there is purely profit sharing principle on both assets and liabilities. In the second model, there is mixed of profit sharing and non-profit sharing principles. The difference lies in the sharing of profit from both models. Consequently, both models have implications for formulating the design and use of tools of monetary policy. JEL Classification: G2; K2; K4; Keyword: monetary policy tools; monetary policy target; Islamic bank behaviour; full reserves; profit sharing ratio; 1 Professor of banking and financial economics, School of Economics, Universiti Kebangsaan Malaysia. He is also AmBank Group Resident Fellow for Perdana Leadership Foundation. This paper will be presented at the International Conference on Islamic Finance, Universiti Malaysia Sabah, 18-19 March 2010 Research Center for Islamic Economics and Finance Universiti Kebangsaan Malaysia Bangi 43600, Selangor, Malaysia Fax: +603-89215789 http://www.ekonis-ukm.my E-mail: ekonis@ukm.my