Final answer:
The correct answer is (a) 'Currency; reserves; smaller.' As depositors increase their currency holdings and banks hold more reserves, the money multiplier effect weakens, and there is a smaller expansion of the money supply than a simple model would predict.
Step-by-step explanation:
The question asks to fill in the blanks with options that describe the effect on the expansion of deposits based on the actions of depositors and banks. The correct answer is: Decisions by depositors to increase their holdings of currency, or of banks to hold reserves, will result in a smaller expansion of deposits than the simple model predicts. When depositors hold more currency, fewer funds are available for banks to use as reserves for lending, which decreases the potential for money creation through the banking system. Similarly, if banks choose to hold onto their reserves instead of lending them out, the process of money creation is further curtailed. This outcome aligns with the fact that banks can opt to hold more reserves during a recession due to an increased risk of loan defaults, as well as in response to changes in reserve requirements set by the Federal Reserve as a monetary policy tool.