Explicit Interest and Demand Deposit Service Charges: Comment

Abstract

In an interesting recent paper, Merris (1985) presented a modification of my (1979) model of the effect of a binding demand deposit interest ceiling upon a bank's choice of the level of the service charge per check. The model assumes bank profit maximization under certaintyS with a perfectly competitive loan market but finite elasticities of consumer demand for savings accounts and demand deposits. My earlier version assumed that the consumer-determined ratio of checks written (n) to demand deposit balances (D) is an ad hoc linear function of the exogenous demand deposit interest rate (rd ) and the service charge per check (b). That model implied that the bank's response to a change in the rate ceiling, db / drd, is ambiguous in sign regardless of whether the savings account rate (rS ) is fixed or flexible. In contrast, Merris considers two alternative versions of the model. In the first, n rather than n / D is assumed in ad hoc fashion to be linear in rS, rd, and b. This feature results in db / drd being unambiguously positive in the case of a fixed rS (though still ambiguous in the case of a flexible rS). His second, and more interesting, version attempts to establish a sound grounding in the preexisting theory of the transactions demand for money. By applying the Barro-Santomero (B-S) (1972) model of the demands for savings accounts, demand deposits, and currency, which has implications for the number of account transactions, he uses nonlinear functions for the quantities of savings accounts (S) and demand deposits (D), as well as for the number of transactions. Merris asserts that the results here are the same as for his linear model: db / drd is unambiguously positive if rS is exogenously fixed (though still ambiguous if rS is flexible). Section 2 of this comment points out two mistakes in Merris's analysis of the model with consumer-theoretic underpinnings, either of which is sufficient to invalidate his analysis and results. Then section 3 shows that, when these mistakes are corrected, the ambiguity in my original paper regarding the sign of db / drd is restored (except in certain special cases).