A Model of Money and Credit, with Application to the Credit Card Debt Puzzle

Abstract

Many individuals simultaneously have significant 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.

Keywords: credit card debt puzzle, search model, model with coexisting money and credit, consumer debt, liquidity

JEL Classification: C78, D11, E41