Credit cards, debit cards and money demand.

King, Amanda S.

CASE DESCRIPTION

The primary subject matter of this case concerns the effect of the introduction of credit cards and debit cards on money demand. The objective is to allow students to apply the results of the four theories of money demand to the changes that are occurring/have occurred in the financial sector. The case has a difficulty level of 3 or 4 and would be appropriate for use in money and banking, financial economics, or intermediate macroeconomics courses. The case is designed to be taught in 1-2 class hours and is expected to require 3-4 hours of outside preparation by students.

CASE SYNOPSIS

John Williams recently returned from a trip on which he realized that he no longer needed cash--not even at fast food restaurants. Everyone accepts credit and debit cards these days. He becomes concerned that this may mean that money is going away. He begins to look into the idea of a cashless society. Certainly credit and debit cards will play a large role in a cashless society. He quickly realizes that to truly understand the impact of credit and debit cards, he will have to understand their impact on money demand (specifically M1 and M2). He researches the four key theories of money demand--The Quantity Theory of Money, Keynes's Liquidity Preference Theory, Friedman's Modern Quantity Theory of Money, and the Baumol-Tobin Model--and comes up with a list of questions applying the impacts of credit cards and debit cards to the results of the models.

INTRODUCTION

John Williams recently returned from a two week road-trip. On his trip he made an interesting observation. Cash and traveler's checks are no longer a necessary part of a "road-tripper's" travel essentials. These days even fast food restaurants accept credit and debit cards. John has heard people speculate about a cashless society in the past and is beginning to wonder if it is starting. He worries that a "cashless" society means a "moneyless" society. John has taken several economics courses in college and has decided to use what he learned in these classes to help him further investigate the role of credit and debit cards in the economy.

JOHN'S RESEARCH

So far he has found a definition for money. Money is any object or commodity that a society generally uses and accepts as a method of payment. It must also serve as a unit of account and store of value. He is relieved to find that a "cashless" society does not mean the same thing as a "moneyless" society. He has also found that money can be classified or measured in several ways. The Board of Governors of the Federal Reserve System collects data on money and then classifies it as either M1 or M2. John has written down the definitions for M1 and M2 that he found at the Board of Governors website in table H.6 Money Stock and Debt Measures.

 M1 consists of (1) currency outside the U.S Treasury, Federal
 Reserve Banks, and the vaults of depository institutions; (2)
 traveler's checks of nonbank issuers; (3) demand deposits at
 commercial banks (excluding those amounts held by depository
 institutions, the U.S. government, and foreign banks and official
 institutions) less cash items in the process of collection and
 Federal Reserve float; and (4) other checkable deposits (OCDs),
 consisting of negotiable order of withdrawal (NOW) and
 automatic transfer service (ATS) accounts at depository
 institutions, credit union share draft accounts, and demand
 deposits at thrift institutions.

 www.federalreserve.gov/releases/h6/Current

 M2 consists of M1 plus (1) savings deposits (including money market
 deposit accounts); (2) small-denomination time deposits (time
 deposits in amounts of less than $100,000), less individual
 retirement account (IRA) and Keogh balances at depository
 institutions; and (3) balances in retail money market mutual funds,
 less IRA and Keogh balances at money market mutual funds.

 www.federalreserve.gov/releases/h6/Current

After a little more searching, John has learned that there are four theories of money demand. At this point he isn't quite sure how these fit into answering his question, but he feels certain they will prove useful. Worst case scenario: he'll call his older sister--a graduate student in economics--and get her opinion. If John has research on theories of money demand and other such topics, his sister will be so impressed she'll have to help him find the answers he is looking for! John has jotted down some notes on the four theories of money demand. His notes are below:

 There are four main theories of money demand These four theories
 are discussed in detail in Miskin 7th edition and Hubbard 4th
 edition. Cecchetti's textbook covers 3 of the 4 in its money demand
 chapter. They are the Quantity Theory of Money, Keynes's Liquidity
 Preference Theory, Friedman's Modern Quantity Theory of Money, and
 the Baumol-Tobin Model.

Quantity Theory of Money: Theory introduced by Irving Fisher in 1911.

--Nominal GDP is affected by the quantity of money in the economy and by velocity.

--Velocity is determined by the institutions and technology of the financial sector of the economy. Short-run velocity is constant. This means nominal GDP is determined by changes in the quantity of money.

--Nominal GDP = total income in the economy

--Put these things together and get that money demand is determined by the level of income in the economy and the fixed technology and institutions in the financial sector.

Keynes's Liquidity Preference Theory: Theory introduced by John Maynard Keynes in the 1930s.

--Households hold money balances for three reasons: 1) to make transactions, 2) as a precaution against unexpected purchases, and 3) as a means of storing wealth. -The third reason (the speculative motive) allows the relationship between money demand and interest rates to be explored.

Friedman's Modern Quantity Theory of Money: introduced by Milton Friedman in the 1950s.

--Treats money and the decision to hold money as it would any other asset.

--The theory of asset demand determines the amount of money that a household chooses to hold.

--Treating money in this way allows for multiple interest rates to play a role in the choice of holding money. -Since banks will compete for deposits when returns on other assets rise relative to the rate of return on money, they will increase the services or interest rates offered. This means that relative returns do not fluctuate and therefore interest rates have no impact on money demand.

--This theory also recognizes that inflation concerns will affect the choice of how much money to hold by allowing physical goods and money to be substitutes.

Baumol-Tobin Model: Two similar models were introduced separately by Baumol and Tobin in the 1950s.

--Households want to hold as little of their earnings as cash at any given time.

--Households want to hold the optimal amount of earnings in interest bearing assets at any point in time.

--At the same time the household wants to minimize its number of trips to the bank (these trips represent transactions costs).

--Thus the household must maximize the amount of earnings in bonds while minimizing transactions costs.

Over Thanksgiving break John told his sister about his research efforts. She was quite impressed and decided to help him out by telling him about the background research she had been doing for one of her professors on debit cards and credit cards. She told him that in many respects credit cards and debit cards look like substitutes. Both allow users to make online and mail order purchases and give the consumer a consolidated listing of their purchases in monthly statements. In most cases, both debit and credit cards are accepted at the same locations since they use the same hardware. In one important way, however, they differ. A credit card is a line of credit and a debit card is not. John is not positive, but he thinks that this difference will make a big difference in whether or not the two media are both considered money. He needs to get back to his notes and double check his definition of money.

John's sister has been reading lots of research about how households use credit cards and debit cards and their impact on different aspects of the economy (one being money demand). This makes John feel quite good--he is researching the same thing that economists are thinking about--maybe he'll be an Econ major after all! John's sister says some households are convenience users of credit cards, meaning that they very responsibly pay off their credit card bill each month. John wants to know, "What's the point?" She tells him that by doing this households may be able to prolong paying for their purchases for up to 45 days. At the same time, they can keep more of their earnings in interest bearing assets. Supporting this, Duca and Whitesell (1995) and King (2004) find that households with credit cards tend to have more money in savings accounts and less in checking accounts. John thinks this sounds pretty interesting but he isn't sure he and most of his friends have the self-control to make this work very well. John's sister agrees that some people don't seem to be able to do this (although research suggests that many households can). She then tells him about other research she has come across that tries to explain why households would use debit cards instead of credit cards. Beyond prolonging bill payments, credit cards have several other nice perks that debit cards typically do not. These include many incentive programs such as airline miles and cash back on purchases. Yet debit card usage has been increasing rapidly in the United States. Reasons households may choose to use debit cards include being able to get cash back while making purchases, thus cutting out a trip to the bank after the shopping trip, and most importantly for many households, avoiding falling back into a pattern that led to serious credit card debt while still maintaining the convenience of electronic payment (King 2004; King and King 2005).

After talking with his sister, John is convinced that the information he has already found is going to prove very useful in helping him to understand the impact of credit cards and debit cards on money demand. His sister gave him a list of papers to check out to get more details on credit cards and debit cards. He decided to wait until after finals to really dive into the new research. Over the last few days he has compiled the following data:

--Debit Card usage increased at an annual rate of 53.3% between 1993 and 1997. (King and King 2005)

--The US lags behind other countries in the adoption of electronic payments. (Humphrey, Pulley, and Vesala 2000;Caskey and Sellon 1994)

--Between 1983 and 1995 credit card borrowing increased at a real rate of 179%. (King 2004)

--People who have had bad experiences with credit cards (i.e. have been in serious debt because of credit cards) tend to have more negative feelings about credit cards. (King and King 2005).

--Median credit card debt in 2001 was $1900 based on Survey of Consumer Finances data. (Aizcorbe, Kennickell, and Moore 2003)

After reading through a mountain of research on credit cards and debit cards, John has had two realizations. First because of the amount of data and research available, he needs to focus his attention very narrowly or he will never get anywhere. Second he feels that he now has plenty of information to tackle the question he initially started with: how will the prevalence of credit and debit cards in the US affect money in the US?

JOHN'S TASK

Several days later, John has decided that the best way to answer his question is by focusing on the four theories of money demand. He has broken his quest down into five questions. The questions are as follows:

1. Typically, economists assume that technological innovations in the banking industry will lead to an increase in the velocity of money.

a) Is this true for the introduction of credit cards? Explain. Does your answer change if you define money as M2 instead of M1?

b) Is this true for the introduction of debit cards? Explain. Does your answer change if you define money as M2 instead of M1?

c) Explain how an increase in velocity would occur for the general case of a technological/financial innovation.

2. Consider the Baumol-Tobin Model.

a) Given the general assumption that households want to maximize interest earned on "bonds" while minimizing the number of trips made to the bank to switch between bonds and money, which instrument should households use, credit cards or debit cards?

b) How would the model predict that M1 would be affected if more households began using credit cards to make their daily transactions? How would the model predict that M2 would be affected?

c) Under this model, would there be any reason to use debit cards? Which would be preferable, debit cards or checks?

d) If credit cards were used according to this theory, would consumer credit debt levels rise? Why or why not?

3. Keynes's Liquidity Preference Theory asserts that there are three motives for holding money--1) a transactions motive 2) a precautionary motive and 3) a speculative motive.

a) Which motives would be affected by the introduction of credit cards into the economy? What would be the end result on money demand based on Keynes's Liquidity Preference Theory? Explain.

b) Which motives would be affected by the introduction of debit cards into the economy? What would be the end result on money demand based on Keynes's Liquidity Preference Theory? Explain.

4. Based on Friedman's Modern Quantity Theory of Money, when would you expect credit card usage to rise, as interest rates in the economy rise or as they fall? When would you expect debit card usage to rise, as interest rates in the economy rise or as they fall?

5. Based on the four theories of money demand, are there any generalizations that can be made about what occurs when credit cards are introduced into the economy? What about when debit cards are introduced into the economy? If there are similarities among the results generated by each model, why do four theories of money demand persist in economics?

REFERENCES

Aizcorbe, A. M., A. B. Kennickell, & K. B. Moore (2003). Recent Changes in US Family Finances: Evidence from the 1998 and 2001 Survey of Consumer Finances. Federal Reserve Bulletin, 89(1), 1-32.

Caskey, J. P. & G. H. Sellon, Jr. (1994). Is the debit card revolution finally here? Economic Review Federal Reserve Bank of Kansas City, Fourth Quarter, 79-95.

Cecchetti, S. G. (2006). Money, Banking, and Financial Markets. McGraw, Hill, Irwin.

Duca, J. V. & W. C. Whitesell (1995). Credit Cards and Money Demand: A Cross-sectional Study. Journal of Money, Credit, and Banking, 27, 604-623.

Federal Reserve Bank. H.6 Release--Money Stock and Debt Measures. http://www.federalreserve.gov/releases/h6/Current/.

Hubbard, R. G. (2001). Money, the Financial System, and the Economy. 4th edition, Addison Wesley.

Humphrey, D. B., L. B. Pulley, & J. M. Vesala (2000). The check's in the mail: Why the United States lags in the adoption of cost-saving electronic payments. Journal of Financial Services Research, 17, 17-39.

King, A. S. (2004). Untangling the Effects of Credit Cards on Money Demand: Convenience Usage vs. Borrowing. Quarterly Journal of Business & Economics, 43(1&2), 57-80.

King, A. S. & J. King. (2005). The Decision between Debit and Credit: Finance Charges, Float, and Fear. Financial Services Review, 14(1), 21-36.

Mishkin, F. S. (2004). The Economics of Money, Banking, and Financial Markets. 7th edition, Pearson Addison Wesley.

Amanda S. King, Georgia Southern University