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The Conundrum of Zero APR: An Analytical Framework

Author

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  • Lukasz A. Drozd
  • Michal Kowalik

Abstract

We document the prevalence of promotional pricing of credit card debt in the U.S. and develop an analytic framework to study how interest rates on multiperiod credit line contracts should be set when debt is unsecured and defaultable. We show that according to the basic theory of unsecured credit — suitably extended to allow for promotions — interest rates should price in the expected default risk on a period-by-period basis. The inspection of our model’s mechanism implies that time-consistent consumption behavior is crucial for this result; accordingly, modeling time-inconsistent consumption behavior can be one means of rationalizing promotions — as we also discuss.

Suggested Citation

  • Lukasz A. Drozd & Michal Kowalik, 2023. "The Conundrum of Zero APR: An Analytical Framework," Working Papers 23-06, Federal Reserve Bank of Philadelphia.
    • Handle: RePEc:fip:fedpwp:96167
    DOI: 10.21799/frbp.wp.2023.06
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    More about this item

    Keywords

    zero APR; credit cards; promotional introductory offers; unsecured debt;
    All these keywords.

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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