Academic journal article Atlantic Economic Journal

Do Credit Cards Really Reduce Aggregate Money Holdings?

Academic journal article Atlantic Economic Journal

Do Credit Cards Really Reduce Aggregate Money Holdings?

Article excerpt

Introduction

As the number of non-cash transactions moves more and more toward electronic forms of payment, it becomes more important to understand the impact that these media have on the economy. In 21 years, from 1979 to 2000, the percentage of non-cash transactions made with checks fell by 26.2 percentage points (Gerdes and Walton 2002). From 1983 to 1995 there was a 179% real increase in credit card borrowing (King 2004). These statistics confirm that changes in the ways households make purchases have been occurring in the economy. Given the magnitudes of these changes, we need to ask how the new payment methods impact our understanding of money demand and money creation process.

Akhand and Milbourne (1986) have investigated how growth in the use of credit cards affects aggregate household money holdings. With credit cards as a means of deferring payment, indeed, households may make payments to credit card banks periodically and hence hold less money on a regular basis. Certainly, this has been shown to be true for individual households (Duca and Whitesell 1995; King 2004). On the other hand, however, credit card banks must make payments to merchants constantly on behalf of cardholders. Hence, credit card banks need to maintain a certain level of money for this purpose.

This paper attempts to examine whether, and how much, the use of credit cards really reduces the aggregate demand for money in an economy. We develop a modified Baumol-Tobin model (Baumol 1952, and Tobin 1956) to study how much money a credit card bank would normally maintain. Aggregate money demand has two components: money holdings by households and money holdings by credit card banks. We show that whether or not the use of credit cards reduces the aggregate demand for money depends on how often consumers visit the bank and how long it takes to clear a check. With innovations in the banking industry such as ATMs, online banks, and other automatic funds transfer services, the cost of "visiting the bank" (i.e., switching funds between a checkable account and an interest-earning account) is very low. For the whole economy, therefore, the use of credit cards may not really reduce aggregate money holdings as the previous studies suggested.

The rest of the paper is organized as follows. The next section briefly discusses the concept of money and points out that credit card banks do demand money to support retail transactions, but they do not create money. Then a section which examines household money holdings with and without credit cards is presented. Then, the money holdings of a credit-card bank is analyzed. Then the next section compares aggregate money holdings with and without credit cards. The section after that considers some of the institutional aspects of the credit card bank. The last section concludes the paper.

Credit Cards and Money

A credit card (service) is a means of deferring payment (Mankiw 2006, p.231). At the time of the transaction, a credit card holder does not have to have any money in either her own account or in an account at her credit card bank. Instead, the credit card bank makes payment with its own money immediately on behalf of its cardholders. Alternatively, one can imagine that the credit card bank has purchased the goods or services and loaned them to its cardholders. Later, the cardholder repays the credit card bill. As a constant big buyer, therefore, a credit card bank must hold money on a regular basis.

Table 1 shows a simplified balance sheet for a credit card company. Normally a credit card bank issues short-term debt or securitizes its receivables (the source of funds) to provide short-term credit (the use of funds) in order to support retail trade. Hence, the credit card bank's assets primarily consist of reserves and credit card loans. For ease, assume a pure credit card company deposits its reserves in a checkable account with another commercial bank, while for a bank-holding company that also runs a credit card business, the reserves may be deposited in an account in its own commercial bank division. …

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