Consumption, Credit Cards, and Monetary Policy

Transcription

1 RESEARCH PROPOSAL: Consumption, Credit Cards, and Monetary Policy By: Mujtaba Zia, Ph.D. Candidate University of North Texas Department of Finance Abstract Oftentimes the purpose of a monetary policy action implemented by the Federal Reserve System involves decreasing the cost of borrowing to stimulate the economy through consumption. Given the growing use of credit cards by consumers, the effects of credit card loans and its implications in the context of monetary policy have not been adequately investigated. In this paper, I propose a research methodology to fill this gap and shed some light on the implication of credit card loans in the context of monetary policy. Key words: interest rates, consumer loans, credit card, monetary policy 09/11/2013 0

2 Section I. Introduction: Theories of monetary policy and how it affects the supply of money and in turn the aggregate demand have been widely studied. Most researchers agree that monetary policy can, at least in the shortrun, affect the course of real economy. An expansionary monetary policy is believed to decrease the cost of borrowing, increase the availability of credit, and encourage investment and/or consumptions which in turn will create aggregate demand and affect the level of real economy. Friedman and Scwartz (1963) asserted that monetary policy actions are following by movements in real output that may last for a year or two. Other researchers empirically confirmed Friedman and Scwartz s theory (Romer and Romer, 1994, Bernanke and Blinder 1992, Christiano, Eichenbaum, and Evans 1994). However, these studies were conducted in a financial environment where financial innovations were still raw and credit cards were not widely used as a medium of transaction and a tool for instant loans. Since 1951, when the first bank credit card appeared in New York's Franklin National Bank for loan customers, credit card use in the United States has increased dramatically. Over the past two decades, with the invention of internet and the popularity of online shopping, credit cards popularity has exponentially increased and they have become an important aspect of American households. For the first time in September 1958, a third party issuing credit card was introduced by Bank of America in Fresno, California and widely accepted by other banks and merchants. The card was named BankAmericard and later to be known as Visa. Few years later in 1966 the Citibank introduced its Charge Card (later evolved into Master Card) in competition to BankAmericard 1. Since 1968 the use of credit cards has increased more than 500 times. In the first quarter of 1968 the total amount of credit card debt outstanding was 1.4 billion, billion by end of 1990 and billion in September These facts indicate that credit cards play an important role in households purchasing power enabling them to finance daily consumption as well as durable goods. In a study of Master Card holders, Chimerine (1997) finds out that about 20 percent of aggregate consumption was being purchased using credit cards between 1990 and With the increasing trend in credit card use, this figure could be much higher today. About 98 percent of all revolving debt is in the form of credit card debt. Moreover, as of 2009, 47% of families have credit card loans 3. The revolving nature of credit card loans makes these loans considerably longterm as well. Given these facts, credit cards may have considerable effects on consumers purchasing power and consequently on the consumption level and the economy. Results from a laboratory experiment suggest that consumers underestimate or forget credit card purchases because the act of paying by credit card is less painful than paying by cash or check (Soman 2001). Hence, credit card use may stimulate spending beyond consumer s rational thinking. While current monetary policy targets the federal funds rate, its ultimate purpose is to provide funds in the economy in order to stabilize and/or improve the state of the economy by lowering the cost of borrowing. While the federal funds rate is directly and almost instantly affected by monetary actions of the fed influencing the cost of borrowing for banks and financial institutions, the cost of borrowing for households may or may not be affected significantly. It is a question of how elastic the interest rates on consumer loans are to monetary policy changes. Given the ratio of revolving consumer debt to total consumer debt of about 35 % as of the fourth quarter of 2010, and credit cards debt comprising 98 % of the revolving consumer debt 4, the change in the cost of borrowing via credit cards may have significant 1 Source: Wikipedia.com 2 Source: Board of Governors of the Federal Reserve System: Statistical Release G.19 Consumer Credit November 7, Source: Board of Governors of the Federal Reserve System: Economic Research and Data, Survey of Consumer Finances 4 Self calculations based on Survey of Consumer Finances (G.19), reported by Federal Reserve System s board. 1

3 implications for monetary policy, especially when monetary policy is aimed to stimulate consumption level in the short run. One important implication of borrowing through credit card in the context of monetary policy is that monetary policy may have an inverse effect. This results from the relatively stickiness of credit card interest rates. Calem and Mester (1995), in an empirical study of interest rates changes during 1989 and 1999, confirm the stickiness of credit card interest rates. Understanding the effectiveness of monetary policy on aggregate consumption and aggregate demand requires knowing the short-term and long-term consumption elasticity of household consumption to changes in the consumer loan rates and the elasticity of consumer loan rates to changes in the federal funds rate. Theory suggests that when an expansionary monetary policy decreases the federal funds rate, the rate on other funds, particularly on funds available for consumption in the form of credit card loans should also decrease, resulting in an increase in the demand for consumer credits, and ultimately an increase in aggregate consumption. Since credit cards serve as the only major source of short-term household credit, and possibly a significant source of fund in the long-term as well, looking at the elasticity of credit card rates to the federal funds rate could reveal interesting implications in the mechanism of monetary policy through credit card channel. In this paper I propose a research methodology in an attempt to answer how credit card interest rates respond to changes in the federal funds rate, how the availability of consumer credits in the form of credit card changes in response to the rates on credit card loans, how consumer expenditures react to changes on the cost of borrowing through credit cards, and ultimately how the consumer expenditures respond to the changes in monetary policy through the credit card channel. The rest of this paper proceeds as following: In section II, I will review the literature and outline prior research conducted in this area, in section III, I will present the research questions and propose the methodology, and in section IV, I will conclude with a summary. Section II. Literature Review: The increasing popularity of automatic gas pumping machines at gas stations, the automatic dispensing machines at shopping centers, the venues at the airports, and the online shopping has made credit cards almost a necessity tool for transactions. Such trends might partly have developed because of the convenience of transaction the credit cards have provided. In some cases like buying an airline ticket or booking a hotel, credit card has become an absolute necessity reducing transaction demand for cash. Baumol (1952) illustrates that a stock of cash is its holder s inventory of the medium of exchange and like an inventory of commodity, cash is held because it can be given up at the appropriate moment, serving as its possessor s part of the bargain in an exchange. He proclaims the necessity that one should carry or hold a certain amount of cash based on the expected amount of transactions as the transactions demand for cash. The transaction convenience credit cards provide reduces the transaction demand for cash because the credit in credit cards can be used as a medium of exchange in transactions, yet having zero cost in the term of interest charge until the transaction is performed. Moreover a majority of credit cards have grace period that if the balance is paid in full by the end of the billing period, no interest rate will be charged. In addition to providing transaction convenience, credit cards provide liquidity services by allowing consumers to avoid some of the opportunity cost of holding cash. Mandell (1972) empirically confirms the transaction demand theory set by Baumol (1952) using the 1970 Survey of Consumer Finances (SCF) and finding that families with credit cards had smaller demand deposit balances than those without, but that the difference was not statistically significant. White (1976), however, found that credit cards significantly reduced household demand deposits. Taking the opportunity cost of holding cash into consideration, Tobin (1956) develops a theoretical model of interest elasticity of transaction demand for cash and illustrates that the shorter the 2

4 period between transactions of funds received and funds expended, the more elastic is the transaction demand for cash in response to yield on bonds. He elaborates: suppose that an individual receives $100 at the beginning of each month and evenly distributes a monthly total of $100. His cash balance would vary between %100 at the beginning of the month and $0 at the end of the month. On average his cash balance would equal $50, or 1/24 of his annual receipts and expenditures. If he were paid once a year, his balance would be 1/2, if he were paid once a week it would be 1/104. In the framework of Tobin (1952), one could think of credit cards as a perfect substitute for cash holdings or carrying credit card debt as the opposite of cash holding and infer that credit card use is highly elastic in response to the credit card interest rate for a rational consumer. Gross and Souleless (2002) conducted a related study using a random sample of 2400 credit card accounts between 1995 and 1998, issued by several anonymous banks in the US and found that the long-run ( 12 or more months) elasticity of credit card debt to credit card interest rate was approximately -1.3, of which was accounting for balance transfers. They found that the elasticity in absolute terms was statistically higher to a decrease in credit card rates than to a rise in interest rates. They also found that an increase in the credit limit generated an immediate and significant rise in debt. While the marginal propensity to consume (MPC) out of liquidity was much larger for people starting near their credit limit, MPC for people starting well below their credit limit was statistically significant as well. Their results are statistically significant and robust. On the other hand, Brito and Hartley (1995) found that consumers behave irrationally using credit cards and paying higher interest rates on credit card debt than on similar bank loans or their own savings. They provide a rational explanation for this behavior and argue that the transaction cost of using credit card debt within the credit limit is literally zero while the transaction cost on alternative loans is considerably higher and that there is no minimum limit to using credit card debt. Therefore consumers prefer credit card debt to alternative bank loans even if the interest rate on credit card debt is much higher. Ausubel (1991) confirms that credit card issuers have persistently earned 3 to 5 times the ordinary rate of return in banking during the period He attributes this to the failure of competition and lack of regulation in the credit card market. The next issue we would like to know is whether credit card interest rates are responsive to changes in the fed funds rate. Calem and Mester (1995) conducted an empirical study of credit card interest rates and consumer behavior between 1989 and 1991 when the prime rate dropped from 11.5 percent to 7.5 percent and the interest rate on large denomination CD s fell from around 9 percent to 5 percent, while bank credit card interest rates stayed fixed at 18-20%. They argue that the historically slow response of credit card rates to changes in money-market rates is consistent to imperfect competition, confirming the work of Ausubel (1991). In another study, Mester (1994) provides explanation to the stickiness of credit card interest rates arguing that because credit card issuers can estimate the behavior and future income prospective of its customers, a decrease in the fed funds rate have ambiguous effects on credit card rates and therefore should not necessarily change the credit card interest rates. In a more recent study, Kerr and Dunn (2008) investigated credit card consumer behavior in changing credit card market and found that consumers with high credit card balances engage in more search for lower and alternative loans, while consumers with low credit card balances tend to stay with the current terms of the credit card and not search for alternative loans and/or lower rates. They also point out that the increase in competition in the credit card market, the prescreening of consumer credit worthiness, and direct solicitations have decreased the cost of searching for lower interest rates. 3

5 Section III. Research Question and Methodology: A: Research Question: The review of literature in the previous section yields an indication that the response of consumption to credit card funds availability and interest rates might be elastic, specially that competition in credit card market has improved and the relatively higher returns in this market still exists. It also indicates that historically credit card interest rates are sticky and do not respond to changes in fed funds rate. If credit card interest rates were elastic in response to changes in fed funds rate, monetary policy would have a multiplier effect in the consumption level through credit card funds availability. The stickiness of credit card interest rates complicates the implication of monetary policy through credit card channel, yet the magnitude of elasticity of credit card interest rates could reveal the direction of a monetary policy effect on consumer spending. Answers to the following research questions will shed light on this issue. 1. How elastic is consumer spending to changes in credit card interest rates? 2. How elastic is consumer spending to changes in credit card limits? 3. How elastic is credit card interest rates to changes in fed funds rate? 4. How elastic is credit card funds availability for consumers to changes in fed funds rate? These questions would determine the course and magnitude of a monetary policy effect on consumer spending and thus on aggregate consumption and ultimately on the state of the economy. B: Data collection and Methodology: Calculating the aforementioned elasticity measures require regression and time-series analyses of credit card balance on credit card interest rates and credit card limit changes. In order to perform the analyses, we need data on credit card accounts open as of 2011 or 2010 at major credit card issuers. Even a random sample of the credit card accounts will be adequate for the regression analyses. Gross and Souleless (2001) uses proprietary data coming from the account archives at several major issuers of credit cards in order to calculate credit card balance use. Each issuer provided a random sample of all their personal bankcards open as of Next we will need data on the credit card limit increases or decreases in response to changes in the federal funds rate. Calculating the elasticity of credit card limit changes to federal funds rate requires regression analysis. The ordinary least square (OLS) regression of credit card limits on the fed funds rate, all in natural log form, will give us the fed funds rate elasticity of credit card funds availability. Theory suggests that credit card limit changes as a result of changes in the amount of available funds because of changes in the fed funds rate. However, a time series analysis may also be necessary to check whether credit card limit changes are due to fund availability that affect federal funds rate or due to fed funds rate affecting fund availability for credit card loans. In order to check the direction of the causality, we need vector autoregressive (VAR) models and response functions to perform granger causality tests in order to determine the direction of the relationship. It is important to mention that by credit card limit changes, I mean automatic credit card limit changes and not card line increase requested by consumers, which is referred to as manual changes in the industry. In order to count for this important distinction of credit card fund changes due to fed funds rate, I will include a dummy variable for manual changes in the credit card limits. 4

6 When performing the analyses, it is important to distinguish between credit card uses for transactions and for borrowing. In order to do this, I would propose using only interest-incurring credit card debt. An alternative data set to proxy for changes in consumption in response to changes in credit card rates and consequently changes in credit card rates in response to fed funds rate could be obtained from the Survey of Consumer Finances (SCF), the G.19 data series compiled by the Federal Reserve System, and aggregate credit card interest rate changes in response to fed funds rate from G.20 data series also compiled by the Federal Reserve System. G.19 reports all aggregate finances of US consumers such as outstanding balances on car loans, mortgage loans, consumer loans, and credit card loans together with average credit lines. G.20 reports the average of interest rate charges and incomes for the financial companies, including credit card issuing firms. G.20 states the average rates charged on different loans including credit card loans. Both G.19 and G.20 data series include quarterly data since 1968 and are available to public through Federal Reserve System. Historical data on fed funds rate is also available through Federal Reserve System, Wall Street Journal, or Bloomberg. Hence, a proximate data set can be obtained that will utilize this study. Section IV. Summary: Monetary policy and its implications on the aggregate consumption and economy have been extensively investigated by researchers. However, its implication through the credit card funds channel has not been investigated. Over the past two decades with the publicity of internet, credit card has become a major tool utilizing transactions, serving as a medium of exchange, and providing consumers with an instant access to consumer loans. It is this instant accessibility to consumer loans that might make credit cards important in the monetary policy implications. In this paper, I propose a methodology to investigate the implications of monetary policy via the credit card channel. The elasticity of consumer credit card use in response to the availability of credit loans, and the elasticity of credit card loan availability to fed funds rate will shed some light on the effects of the monetary policy on aggregate consumption through credit card channel. 5

7 References: Ausubel, Lawrence M., The Failure of Competition in the Credit Card Market, The American Economic Review, Vol 81, No. 1, (March 1991), Baumol, William J., The Transaction Demand for Cash: An Inventory Theoretic Approach, The Quarterly Journal of Economics, Vol. 66, No. 4, (November 1952), Bernanke, Ben, and Alan Blinder, The Federal Funds Rate and the Channels of Monetary Transmission, American Economic Review, 82, (September 1992), Brito, Dagobert L., and Peter R. Hartley, Consumer Rationaltiy and Credit Cards, Journal of Political Economy, Vol. 103, No. 2, (April 1995), Calem, Paul S. and Loretta J. Mester, Consumer Behavior and the Stickiness of Credit Card Interest Rates, American Economic Review, Vol. 85, Issue 5, (December 1995), Chimerine, L. (1997). The New Economic Realities in Business. McKinsey Quarterly, 86(1), Christiano, Lawrence, J., Martin Eichenbaum, and Charles Evans, The Effects of Monetary Policy Shocks: Evidence from the Flow of Funds, The Review of Economics and Statistics, Volume 78, No.1 (February, 1996), Friedman, Milton and Anna Schwartz (1963), The Monetary History of the United States , New Jersey, Princeton University Press. Gross, David, B., and Nicholas S. Souleles, Do Liquidity Constraints and Interest Rates Matter for Consumer Behavior? Evidence from Credit Card Data, Quarterly Journal of Economics, 117:1 (2002), Kerr, Sougata and Lucia Dunn, Consumer Search Behavior in the Changing Credit Card Market. Journal of Business and Economic Statistics, vol. 26, No.3, (2008), Mandell, Lewis. Credit Card Use in the United States. Ann Arbor, Mich.: Institute for Social Research, Mester, Loretta J., "Why Are Credit Card Rates Sticky?" Economic Theory, May 1994, 4(4), pp Romer, Christine D. and David H. Romer, Does Monetary Policy Matters, Journal of Monetary Economics, Volume 34, Issue 1, (August 1994), Soman, Dilip, Effects of Payment Mechanism on Spending Behavior: The Role of Rehearsal and Immediacy of Payments, Journal of Consumer Research. Volume 27, Issue 4, (2001) Tobin, James, The Interest Elasticity of Transactions Demand for Cash, Review of Economics And Statistics. 38 (August 1956),