Did you notice anything missing in the previous depiction? That’s right – there is no mention of THE STATE, which of course cannot be left out of account. The state affects life in many different ways. In terms of economics, its major role is to shape the environment in which economic activity takes place. We have mentioned the indispensable institutions it uses to do that: property, contract, credit and debt relations. It thus specializes in law, and its work extends to marriage law, family law, corporate law, and other areas impinging on economics. Furthermore, it indulges in all manner of environmental, labor, and other regulations which have a massive effect on the economy. Not only that, but it exercises positive functions such as diplomacy and, domestically, HEW (health, education, and welfare) – regardless of what we think of those efforts.
Not all of these activities have a direct economic effect. But the direct economic activity of the state can be broadly summarized as follows: 1) taxation, 2) wealth redistribution and subsidies, 3) public debt and interest payments. These are depicted in the following diagram.
The relation of the state to the central bank is not a direct one but takes place in the financial market. In the US, the usual method is for the government to auction its debt paper (shorter- or longer-term Treasury bonds) to a select group of so-called primary dealers. These in turn deal with the Fed, buying and selling US Treasuries. The Fed engages in these and other “open-market operations” to influence conditions on the financial market. For instance, when it buys up Treasury bonds, it puts more money into circulation and so has the effect of lowering interest rates; when it sells these bonds, it takes money off the market and so has the effect of pushing rates up.