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telyukova_tw - A Model of Money and Credit with Application...

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A Model of Money and Credit, with Application to the Credit Card Debt Puzzle Irina A. Telyukova University of California — San Diego Randall Wright University of Pennsylvania August 27, 2007 Abstract Many individuals simultaneously have signi fi cant credit card debt and money in the bank. The credit card debt puzzle is: 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 — e.g., it readily yields nice existence and characterization results — and helps puts into context recent discussions of consumer debt. We thank Neil Wallace, Ed Nosal, and participants of seminars at Penn, UC-Riverside, UQAM, Essex, the Federal Reserve Banks of Cleveland, Philadelphia and New York, and the 2006 SED meetings in Vancouver for feedback. We thank the National Science Foundation and the Jacob K. Javitz Graduate Fellowship Fund for research support. The usual disclaimer applies. 1
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1 Introduction A large number of households simultaneously have a signi fi cant amount of credit card debt and a signi fi cant amount of low-interest liquid assets, such as money in their checking accounts. There are many ways to measure this, and we discuss some of the empirical issues in more detail in Section 4.2, but for now we o ff er these simple summary statistics from Telyukova (2006): 27% of U.S. households in 2001 had credit card debt and liquid assets both in excess of $500; and the median household in this group revolved around $3,800 on their credit cards even though they had $3,000 in the bank. The so-called credit card debt puzzle is this: given 14% interest rates on credit cards, and 1 or 2% on bank accounts, why not pay down debt? According to Gross and Souleles (2001), “Such behavior is puzzling, apparently inconsistent with no-arbitrage and thus inconsistent with any conventional model.” Some economists have gone to elaborate lengths recently to explain such phenomena. For example, some assume that consumers cannot control themselves (Laibson et al. 2000); others assume that they cannot control their spouses (Bertaut and Haliassos 2002; Haliassos and Reiter 2003); and others hypothesize that such households are typically on the verge of bankruptcy (Lehnert and Maki 2001). These ideas are certainly interesting, may contain elements of truth, and will be discussed further below, but from the outset we want to point out that the credit card debt puzzle is actually not a new observation. Rather, it is another manifestation of the venerable rate of return dominance puzzle from monetary economics. Hence, insights may be gained by using models and ideas from monetary theory, and in particular, by taking seriously the notion of liquidity.
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