A Model of Money and Credit, with Application to the Credit Card Debt Puzzle

Abstract

Many individuals simultaneously have significant credit card debt and money in the bank. The "credit card debt puzzle "is as follows: given high interest rates on credit cards and low rates on bank accounts, why not pay down debt? While some economists go to elaborate lengths to explain this, we argue it is a special case of the "rate of return dominance puzzle "from monetary economics. We extend standard monetary theory to incorporate consumer debt, which is interesting in its own right since developing models where money and credit coexist is a long-standing challenge. Our model is quite tractable-for example, it readily yields nice existence and characterization results-and helps put into context recent discussions of consumer debt. Copyright 2008 The Review of Economic Studies Limited.

Monetary policy in a channel system

“…It is reasonable to assume that n = 1/2 since it means that on average a bank is equally likely to borrow or to provide cash in the money market and also equally likely to be either short of money or have excess cash at the end of the day. The second assumption means that holding collateral has 21 The first two results exactly match the behavior of the overnight money market rate of the channel system operated by the Reserve Bank of New Zealand. This can be seen from Figure 2 in the introduction.…”

“…Second, if nβR = 1/2, then i m = i p . 21 Our model suggests that the money market interest rate lies exactly on the policy rate if, for example, n = 1/2 and βR → 1. It is reasonable to assume that n = 1/2 since it means that on average a bank is equally likely to borrow or to provide cash in the money market and also equally likely to be either short of money or have excess cash at the end of the day.…”

Why Do Poor People Co-Hold Debt and Liquid Savings?

“…Telyukova (2013) estimates a variant of the model by Telyukova and Wright (2008) . Telyukova (2013) shows that much of households' co-holding behaviour is explained by liquidity needs, precisely by the amount and volatility of cash-only consumption, that is, the goods for which a credit card cannot be used.…”

“…3 The theory of liquidity needs-originally formulated by Telyukova and Wright (2008) and Zinman (2007), and later extended by Fulford (2015a)-highlights that liquid deposits are valuable to households for transactions and precautionary 4 purposes. The reason is twofold.…”

Money and credit as means of payment: A new monetarist approach

“…More recently, there are several models featuring divisible money and centralized credit markets using the Lagos and Wright (2005) model, including Berentsen, Camera, and Waller (2007), Telyukova and Wright (2008), Sanches and Williamson (2010), Bethune, Rocheteau, and Rupert (2014), Gu, Mattesini, and Wright (2014), and Liu, Wang, and Wright (2014). However in all these approaches, only an exogenous subset of agents can use credit while the acceptability of credit is endogenous in this paper.…”