Introduction to Finance

primary 
deposit
because it adds new reserves to the bank where deposited and to the banking system. 
A 
derivative deposit
occurs when reserves created from a primary deposit are made available 
to borrowers through bank loans. Borrowers then deposit the loans so they can write checks 
against the funds. When a check is written and deposited in another bank, there is no change 
in total reserves of the banking system. The increase in reserves at the bank where the check 
is deposited is off set by a decrease in reserves at the bank on which the check is drawn. Banks 
must keep reserves against both primary and derivative deposits.
Checkable Deposit Expansion
When reserves were fi rst required by law, the purpose was to assure depositors that banks 
had the ability to handle withdrawals of cash. This was before the establishment of the 
Federal Reserve System that made it possible for a healthy bank to obtain additional 
funds in time of need. Depositor confi dence is now based on deposit insurance and more 
complete and competent bank examinations by governmental agencies. Today, the basic 
function of reserve requirements is to provide a means for regulating deposit expansion 
and contraction.
Deposit creation takes place as a result of the operations of the whole system of banks, 
but it arises out of the independent transactions of individual banks. To explain the pro-
cess, therefore, we will consider the loan activities of a single bank. First, we will focus on 
the bank itself; then we will examine its relationship to a system of banks. This approach 
is somewhat artifi cial since a bank practically never acts independently of the actions of 
other banks, but it has been adopted to clarify the process. Furthermore, it helps explain 
the belief of some bankers that they cannot create deposits, since they only lend funds 
placed on deposit in their banks by their depositors. This analysis shows how a system 
of banks, in which each bank is carrying on its local activities, can do what an individual 
banker cannot do.
For illustration, let us assume that a bank receives a primary deposit of $10,000 
and that it must keep reserves of 20 percent against deposits. The $10,000 becomes a 
cash asset to the bank as well as a $10,000 liability, since it must stand ready to honor a