Why do people simultaneously hold substantial cash and high interest credit card debt? I previously reported that this could be explained by the demand for liquidity as some goods cannot be purchased on credit. While that explanation seemed to be a good one quantitatively, it does not mean that thtere is no room for other ones as well.
Scott Fulford offers another one: liquidity is necessary for unexpected changes in borrowing limits. Basically, people keep cash or savings so that they have something to live from in case their credit line gets unexpectedly reduced. That seems to be a very poor strategy, though. Given the high interest rate on credit cards, why not lower the credit balance with those savings? You pay less interest, and you end up with exactly the same balance when you are the most constraint. If fact you are even better off in the latter situation, because past interest payments are lower and the balance is thus lower. The reason why household in this model still hold cash is that there is a very peculiar way in which the debt limit is stochastic: it is either zero or some fixed number. Thus it is not some reduction in credit lines, it is a complete cancellation out of the blue. That is important for household choices. In fact, this may give some ideas to credit card companies, because this implies that households will want to have high interest credit card debt while having low interest savings. Crazy.
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