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.

INSTRUCTORS' NOTES

This case allows students to apply a financial innovation to the models of money demand. Thus the case allows the students to work with the theories of money demand that they have encountered in lecture and interpret results given a change in the financial market. This case would be an especially useful way to end a section on money demand since it reinforces the traditional theories while allowing students to think about credit and debit cards, two methods of payment that they are very familiar with.

CASE QUESTIONS AND ANSWERS

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.

a) Credit cards may function in two ways, as a method of borrowing and as a medium of exchange. If we assume that the card is functioning as a medium of exchange, then the number of purchases made with cash or checks should fall, leading to a decrease in money demand (when money demand is defined as M1), and therefore an increase in velocity. (Recall that velocity is defined as PY/M and thus if total purchases remain unchanged but less are made with M, M falls and thus V rises.) If we define money as M2 instead of M1 our answer depends on how households hold the income that they are not using immediately to make transactions. If this income goes into something such as a savings account then M2 is unaffected--income is merely transferred from an account that is more liquid to one that is less (recall M1 is part of M2). This would seem the reasonable reaction of households that plan to pay off the credit card bill at the end of the month. If the households move the money into other types of even less liquid assets though, M2 could fall as well. Given that the card is being used as a medium of exchange and NOT a method of borrowing this seems less likely.

If the credit card is functioning as a method of borrowing, velocity may remain unchanged. Households continue to demand the same level of money in order to make their standard purchases and then make extra purchases. b) The introduction of debit cards should not change velocity when money demand is defined either as M1 or M2. In order to use the debit card instead of cash, deposits equal to the value of the cash must be available. Both cash and deposits are money so M1 doesn't change. Since M1 is included in M2, M2 does not change either.

c) Assume a financial innovation that allows households easier access to funds. The household does not need to hold as many funds in M1 or M2 at any given time. Thus M decreases while PY remains unchanged. Since velocity= PY/M, this leads to an increase in velocity.

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 revolving credit (credit debt) levels rise? Why or why not?

a) Credit cards should be used. The use of credit cards allows households to hold their earnings in some sort of interest bearing asset for longer, because the use of the credit card allows them to make purchases while postponing payment.

b) M1 should fall if more households begin using credit cards to make their daily transactions based on Baumol-Tobin. This is because households should move money out of M1 and into accounts that have higher yields (such as savings accounts or money market accounts). M2 might not be affected at all. Money that used to be held in M1 could be moved to M2 and since M1 is included in M2 there would be no change in the overall value of M2 (assuming the "bonds" held based on Baumol-Tobin are assets that help make up M2).

c) Under this model, there is no reason to use debit cards. In fact, paper checks would be preferable. Paper checks take longer to clear than do debit cards, therefore allowing a household's income to stay in an interest bearing account (if it is a checking account with interest) for longer than it would if a debit card is used.

d) If credit cards were used, there would be no reason to expect consumer revolving debt (credit debt) to rise. The household would make purchases on the credit card throughout the month, hold its income in an interest bearing account, and then at the end of the month transfer the amount charged into an account from which the credit card could be paid off.

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.

a) Since a credit card can be used as a method of payment the transactions motive would be affected. Households could use the credit card to make purchases during the month instead of using money, and therefore money demand from this motive would fall. The precautionary motive for money demand would also be affected. Instead of needing to hold large sums of money for emergencies, a household can now choose to hold a credit card to protect against unexpected expenses. The speculative motive should not be affected by the introduction of the credit card. Based on the changes to the transactions motive and the precautionary motive, money demand based on Keynes's Liquidity Preference Theory would decrease.

b) A debit card is a plastic/electronic check. It clears faster than a paper check but in essence it is still a check. Its introduction into the economy should have no impact on any of the motives in Keynes's Liquidity Preference Theory. It is merely a different way of writing a check. If, however, people perceive that the transactions costs of using a debit card are less than the transactions costs of using a credit card (or even using a paper check), the introduction of the debit card could actually induce more people to hold more money in order to take advantage of the ease of electronic payments without the pitfalls of credit. (The major increase in transactions costs of credit over debit would be the possible danger of falling into debt.)

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?.

(Note to the instructor: this question is a "trick" question in that it is asking about movement in all interest rates, but what really matters in this particular model are changes in relative interest rates. This question also leads to the opportunity to talk about shortrun versus long-run outcomes, as Friedman's result is really a long-run result. Interest rates will not adjust immediately in all markets.)

Friedman believed that the when the interest rate on other assets rises, banks will begin to compete to keep deposits coming in, thereby raising the return on money. This means that the spread between the return on money and other assets will remain constant. Thus, in this model, interest rates have no effect on the demand for money. According to the results for Friedman's Modern Quantity Theory of Money, changes in interest rates should have no impact on credit card or debit card usage because they should not affect the level of money that households desire to hold. This however, could be considered a longrun result (the zero profit result in a competitive market). In the short-run, however, relative shifts in the interest rates on bonds and equity could lead to changes in the demand for money. As the interest rate on bonds or equity rise (before banks have time to adjust to the change) the relative spread on the interest rates will rise, leading to a decrease in money demand. In order to keep consumption levels constant, you would expect credit card usage to increase as the relative spread between bonds or equity and money increases (which would lower the demand for money), and credit card usage to decrease as the relative spread between bonds or equity and money decreases (which increases the demand for money). As the relative spread between bonds and equity and money rises in the short-run, you would expect debit card usage to fall as money demand falls. As the relative spread between bonds and equity and money falls in the short-run, you would expect debit card usage to increase as money demand rises.

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?

In every case, if credit cards are used by convenience users (so as a method of transaction not as a method of borrowing) then money demand will decrease. Since debit cards are plastic/electronic checks, money demand should not be affected by their introduction. If however, consumers feel that it is easier to make transactions because of the debit card and increase their level of spending then money demand could increase. Each of the theories of money demand allows economists to focus on a different aspect of the economy. In some instances new theories were introduced as a means of explaining a phenomenon that one of the other theories was unable to explain (for example, the Quantity Theory of Money cannot deal with the relationship between money demand and interest rates but Keynes's Liquidity preference adds in assumptions that allows it to deal with this issue). In other instances, the focus changes from economy-wide impact to household level (the

Baumol-Tobin model takes the individual perspective; the others give a more aggregate perspective).

Note to the instructor: For those who wish to add some discussion of international ramifications of the introduction of credit and debit cards, ask students to consider how credit and debit cards impact the international demand for dollars. The discussion could proceed as follows.

In general, credit and debit cards should not impact the international demand for dollars. Many credit and debit cards are accepted worldwide. If a British consumer wants to make a purchase in New York City, she may do so with her credit card or debit card. Has the purchase taken place in pounds instead of dollars? No. The credit card bank handles the exchange from pounds to dollars for the consumer instead of the consumer making the exchange before making the purchase. From this perspective, the international demand for dollars should remain unchanged. However, if foreign consumers perceive that it is now easier to make purchases abroad, their consumption behavior could change. If the foreign consumer is now more willing to make purchases abroad, because the trouble of exchanging currency has been eliminated, then the demand for foreign currency (dollars in this case) could increase.

This could lead to interesting discussions on exchange rates, balance of trade, and the regulatory environment for international financial markets.

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