Final answer:
The initial impact of households and firms holding less money in checking accounts and more in currency will not change the total money supply but will alter its composition. The concepts of open market operations and the money multiplier effect are key to understanding how banking activities, like loans, can expand the money supply.
Step-by-step explanation:
If households and firms decide to hold less of their money in checking account deposits and more in currency, then initially the money supply will not change. This is because the total money supply includes both currency and checking account deposits as parts of its definition. However, the components of the money supply will change, with an increase in currency circulation and a decrease in demand deposits.
To explain this further in the context of open market operations and banking, making loans that are deposited into a demand deposit account increases the M1 money supply. The M1 money supply includes checkable (demand) deposits and currency in circulation. When the central bank conducts an open market operation, such as purchasing bonds from a bank like Happy Bank, the bank's reserves increase. Happy Bank then loans out the excess reserves, which results in an expansion of the money supply due to the money multiplier effect. As the new loans are deposited into checking accounts, other banks loan out these deposits, further increasing the money supply.