Introduction to Finance

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5.6
Changing the Money Supply
As we saw in Chapter 2, the M1 money supply consists of currency (including coins), demand 
deposits, other checkable deposits, and traveler’s checks. Currency is in the form of Federal 
Reserve notes and is backed by gold certifi cates, 
Special Drawing Rights (SDRs)
, eligible 
paper, or U.S. government and agency securities. SDRs are a form of reserve asset, or “paper 
gold,” created by the International Monetary Fund. Their purpose is to provide worldwide 
monetary liquidity and to support international trade. Eligible paper in the form of business 
notes and drafts provides little collateral today. Instead, Federal Reserve notes have been 
increasingly backed by government securities. 
Demand deposits and other checkable deposits at commercial banks, S&Ls, savings 
banks, and credit unions comprise about one-half of the M1 money supply and are collectively 
termed 
checkable deposits
. To simplify further discussion of money supply expansion and 
contraction, we will refer to checkable deposits simply as 
deposits 
in the 
banking system
, 
which includes all of the depository institutions. The word 
bank
also is used generically to 
refer to a depository institution.
The banking system of the United States can change the volume of deposits as the need 
for funds by individuals, businesses, and governments change. This ability to alter the size of 
the money supply is based on the use of a 
fractional reserve system
. In the U.S. fractional 
reserve system, banks and other depository institutions must hold funds in reserve equal to a 
certain percentage of their deposit liabilities. Vault cash and funds held at regional Reserve 
Banks comprise bank reserves. To understand the deposit expansion and contraction process, 
one must study the operations of banks as units in a banking system and the relationship of 
bank loans to deposits and to bank reserves.
In analyzing deposit expansion, it is helpful to distinguish between primary deposits 
and derivative deposits. For example, the deposit of a check drawn on the Fed is a