Riba and Financial
Dr. Mohammad Omar Farooq
Associate Professor of Economics and Finance
Upper Iowa University
2/9/07; Message #6244
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In response to:
Dear Br. Irfan,
"It may or may not be
immediate, but you have avoided asserting any of its effect by defusing it in
income statement, however when you identified it as an expense in the income
statement, will that expense be counted towards cost? Where that expense will
be accounted for?"
First, thank you for acknowledging that the effect
of interest on loan is neither immediate nor directly on the balance
sheet. Another word, it can't be shown as balance sheet entries as your
original framing of this issue attempted. As long as you realize and
acknowledge this, the next issue then is how does it work through the income
statement. That's a legitimate query.
"If adjusting the
expense is not feasible due to any market reason like price war etc., and the
borrower’s financial strength (net worth) has the capability to absorb the
expense, then the borrower will not increase the price at the cost of debiting
its net worth. There are other scenarios possible that the borrower has
managed increased efficiency and able to offset the extra expense in some
other account. These are all relative factors with limits and not true for
every borrower, the Interest Expense has to be accounted for some where? Where
you will adjust it? I would like to see that."
I think there is a confusion here in terms of cost and price of the product.
Part of the answer you yourself have provided. Please correct me if I am
wrong, but essentially what you are trying to do is connect the dot between
interest (on loan) and inflation.
The first problem with connecting the dot between
interest and inflation is that inflation is a macro phenomenon (reflected in
the general price level). You have to keep in mind that inflation is defined
as, "The rate at which the general level of price for goods and
services is rising." [Link,
Second, cost of production is an aggregate, where
all component cost may go up, all cost may go down, some may go up while
others remain the same, or some may go up while others may go down - all such
possibilities are there. Interest expense may not increase the final cost, if
there are compensating changes (lower expenses for other resources).
Third, cost of production may go up without any
interest expense. If inflation is understood as merely due to cost going up,
then we have to conclude that inflation can be caused not just by interest,
but also by any other aspect of production cost. If that is so, there is no
unique, one-to-one connecting of dots between interest and inflation.
Fourth, it is important to note that even higher
cost on the part of an individual business (a micro picture) does not
necessarily translate into higher price the same business can charge to the
customers, let alone having a macro-level impact. Whether a business can shift
any higher cost to the consumers in the form of higher prices depend of price
elasticity of demand as well as many other economic factors, including
That's why your original framing of the
relationship between interest expense and inflation does not necessarily hold.
Of course, as has already been explained, trying to show the effect
(especially immediately and directly through balance sheet) is erroenous. I
know your work of illustration at your website is partially based on this
premise of interest -> inflation connection, which has also been argued by
several others on this forum. However, I hope that it is quite clear by now
that that argument is just polemical. It is neither theoretically accurate nor
Index of My Writings
Have you visited my other sites?
Kazi Nazrul Islam?