Credit Cards, Debit Cards and Money Demand

By King, Amanda S. | Journal of the International Academy for Case Studies, February 1, 2008 | Go to article overview
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Credit Cards, Debit Cards and Money Demand


King, Amanda S., Journal of the International Academy for Case Studies


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 Ml?

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

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 Ml), 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 Ml 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 Ml 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.

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