The discount rate for equity can be calculated using the CAPM model or the cumulative build model. Rate of return to discount debt-free cash flow calculated using the WACC weighted average cost of capital model. The following is the content of these models and options for substantiating their main parameters in Russian practice. Much is unclear, do not know how to approach the discount rate? Especially for you, then the fifth question)
1. Types of discount rates in business valuation
To discount future cash flows in business valuation, it is necessary to calculate the discount rate, the type of which must correspond to . As shown in the following table, according to the four main types of cash flows in business valuation, there are four types of discount rates.
If the valuation is based on nominal cash flow, then nominal discount rate, which takes into account the effect of inflation. To discount the real cash flow, the real rate discount, which does not take into account inflation expectations.
Rates of return based on actual market data take into account the effect of inflation and are nominal. Therefore, in practice, it often becomes necessary to calculate the real discount rate based on a known nominal rate, for which it can be used Fisher formula:
2. Weighted average cost of capital (WACC) model
The WACC model involves determining the discount rate by summing the weighted rates of return on equity and borrowed funds, where the weights are the shares of equity and borrowed funds in the capital structure. Wherein we are talking on the structure of invested capital, which, in addition to equity capital, as a rule, includes only long-term borrowed funds.
The weighted average cost of capital is calculated using following formula:
WACC = W 1 × Re + W 2 × R d ×(1 – h), where
- W 1 - the share of equity in the capital of the company;
- W 2 - the share of long-term debt in the capital of the company;
- R e - rate of return on equity;
- R d is the cost of borrowed capital (cost of debt);
- h is the effective income tax rate.
3. Capital Asset Pricing Model (CAPM)
The discount rate for equity can be justified using a Capital Assets Pricing Model (CAPM) or a cumulative build model.
Basic SARM Model is used to estimate the expected return of open companies based on the analysis of stock market information, has significant assumptions and a well-defined scope. The basic CAPM model is discussed in detail in educational literature in various financial and economic disciplines (primarily in financial management) and is presented in the following formula:
R e = R f + β ×(R m – R f), where
- Re– required (expected) rate of return on equity;
- Rf — risk free rate of return;
- Rm- the average market rate of return;
- (Rm-Rf) is the average market risk premium;
- β is the beta coefficient as a quantitative measure of systematic risk.
The basic CAPM model occupies an important place in portfolio theory and is based, in particular, on the assumption that a rational investor, by diversifying his investment portfolio, seeks to minimize the non-systematic risks associated with investing in a particular asset. For example, non-systematic risks of investing in a company's shares are due to the nature of its activities - in particular, the level of product diversification, management quality, etc., as well as the company's financial position - primarily, the degree of dependence on external sources financing.
In this regard, the expected return on the basic CAPM model includes a premium only for systematic risk, which is formed under the influence of macroeconomic factors (inflation, economic recession, etc.) and cannot be eliminated by diversifying the investment portfolio.
In the practice of business valuation, in the process of substantiating the rate of return on equity of the company being valued, modification of the basic CAPM model, according to which the basic CAPM model is supplemented (by adding) the following main premiums for the unsystematic risk of investing in the company being valued: From 1– premium for the risk of investing in a particular company; From 2– risk premium for investing in small business; From 3 is the country risk premium.
How to justify the parameters of the CAPM model in Russian practice?
risk free rate of return Rf corresponds effective rate yield to maturity of risk-free assets – i.e. assets that meet the following conditions:
- returns on them are determined and known in advance;
- the probability of loss of funds as a result of investments in the asset is minimal;
- the duration of the circulation period of the asset coincides or is close to the period of the projected period of ownership of the property being valued.
The choice of an asset for calculating the risk-free rate of return is also determined by the calculation currency - for example, to calculate the rate of return for discounting the ruble cash flow, it is reasonable to calculate the yield on a risk-free asset denominated in rubles.
Abroad, the rate of return on government securities is usually used as a risk-free rate. In domestic practice, along with this, as risk-free assets after the 1998 crisis. it was proposed to consider also deposits of the Savings Bank of the Russian Federation and banks of a high category of reliability. However, the use of bank deposit rates as a risk-free rate of return currently seems to be insufficiently justified, which is due to the higher risk of investing in bank deposits compared to government securities and short terms for accepting deposits (one to two years).
Government bonds of the Russian Federation are represented by ruble and foreign currency financial instruments. An example of ruble bonds is federal loan bonds (OFZ), the issuer of which is the Ministry of Finance of the Russian Federation. The owners of these bonds can be both legal entities and individuals, residents and non-residents; auctions and secondary trading are held on the MICEX.
The volume of the currency bond market is significantly higher than the level of the ruble bond market. Foreign currency bonds of the Russian Federation are represented by two types: bonds of an internal foreign currency loan (OVVZ) and eurobonds of the Russian Federation. At the same time, the riskiness of investments in OVVZ is assessed by international rating agencies as higher compared to Eurobonds. In this regard, it is advisable to consider Eurobonds as a risk-free asset to justify a non-ruble (for example, dollar) risk-free rate.
Rationale average market rate of return R m associated with the calculation of the actual return of the market portfolio. In practice, portfolios formed on the basis of broad-based indices are considered as a market portfolio - for example, in the Russian Federation, it is possible to calculate the index of the stock market (Moscow Exchange), news agencies (AK&M), etc.
Coefficient beta (β) as a quantitative measure of systematic risk in the CAPM model, it is calculated using information on the dynamics of the return on shares as investment assets in the stock market according to the following formula:
βi = Cov(R i , R m)/Var(Rm) , where
- βi — measure of systematic risk i-th asset (portfolio) relative to the market;
- cov(R i, Rm) - return covariance i-th asset (portfolio) (R i) and average market returns (Rm) ;
- Var(Rm) – variation in the average market return (Rm).
Thus, the beta coefficient reflects the amplitude of fluctuations in the return of a particular asset (portfolio) compared to the overall return of the stock market as a whole.
The value of beta characterizes how much the risk of owning specific assets is greater or less than the risk of the market portfolio. An asset whose beta is above one is more sensitive to systematic risk than the stock market on average, and, accordingly, is characterized by a higher risk than the average market situation. Accordingly, assets with beta less than one are less risky compared to the market portfolio.
Thus, the higher the beta value of an asset, the higher the level of its systematic risk. The stock price of a company for which the beta coefficient is 1.2, with an increasing trend in the market, will grow on average 20% faster compared to the average market level. And, conversely, when depressed state market, the share price of this company will decrease by 20% faster than the market average. Therefore, if the share price in the stock market falls by 10%, we can expect that the share price of this company will fall by 12%.
Describing the parameters that were added to the basic CAPM model in the process of its adaptation for business valuation purposes, we note that a wide scope has non-systematic risk premium investing in a specific company (C 1).
Small business risk premium (S2) applies if the company being valued is a small business; the purpose of its introduction is to compensate for the additional instability of small business income.
Country risk premium (S 3) is introduced, for example, if the return on equity of a Russian company is estimated according to the parameters of the basic CAPM model, which are calculated according to data from foreign developed capital markets. In this case, the country risk premium is needed to compensate for the additional risks of investing in the Russian Federation compared to developed markets.
To account for country risk, it is necessary to identify the most important factors that determine the risk of investing in a country, as well as develop a method for quantifying risk for the country in question. Among the main factors of country risk, the risk of instability of legislation and the risk of unreliability of property rights are singled out. Under the influence of these factors, the following additional risks may arise: the risk associated with foreign currency conversion; the risk of loss of assets due to possible government actions of nationalization and expropriation; risk associated with restrictive measures on the movement of capital; risk associated with the possibility of state regulation of prices, etc.
The practice of applying the CAPM model in a developed capital market, as a rule, involves the use of ready-made values of the model parameters calculated by specialized companies. In emerging markets, the appraiser usually calculates the parameters of the CAPM model on his own.
Characterizing scope of the CAPM model, we note that the model is unambiguously applicable for estimating the expected return on equity of open companies listed on the stock market. You can also use this model to evaluate a company whose analogues are actively traded on the stock market.
4. Cumulative building model
The model of cumulative construction of the discount rate is used when evaluating closed companies, for which it is difficult to find comparable open companies-analogues and, accordingly, it is impossible to use the CAPM model.
When using this model, the risk-free rate is taken as the basis, to which the premium for the risk of investing in closed companies is added. The cumulative construction model best takes into account all types of risks associated with both factors general(macroeconomic factors and factors of the type of economic activity of the enterprise), and with the specifics of the enterprise being assessed.
The discount rate for the cumulative construction model is calculated using the following formula:
Re = Rf + From 1+ From 2+ From 3+ From 4+ From 5+ From 6+ From 7 , where
- R e– required (expected) rate of return on equity of the company being valued;
- Rf is the risk-free rate of return;
- From 1– risk premium associated with the size of the enterprise;
- From 2– premium for the risk of the financial structure (sources of financing of the enterprise);
- From 3– premium for product and territorial diversification risks;
- From 4– risk premium for customer diversification;
- From 5– risk premium for the level and predictability of profit;
- From 6– risk premium for management quality;
- From 7– premium for other risks.
The specified risk premiums are set for the assessed enterprise in the range from 0% to 5% for each type of premium - with the maximum risk level, the highest premium is set.
The cumulative construction model has an almost unlimited scope. Its main disadvantage is the predominant use of subjective approaches to justify the values of risk premiums. Meanwhile, at present, in separate publications, in the reports of large appraisal firms, methodological approaches are proposed to justify the values of risk premiums in the cumulative construction model. The use of such approaches, while increasing the degree of objectivity and validity of determining the discount rate, at the same time requires significant information both on the enterprise being valued, and on similar companies, and on the market as a whole.
For example, during the assessment size risk premium , it should be taken into account that a large company often has advantages over small ones due to greater business stability, relatively easier access to financial markets if additional resources are required. At the same time, there are a number of industries where small businesses operate more efficiently: trade, catering, public service, production without the use of complex technological processes. Therefore, it is reasonable to estimate the value of the risk premium taking into account the trends prevailing in similar enterprises that are engaged in the same types of economic activity as the enterprise being assessed.
As a result, the risk premium associated with the size of the company can be determined by the following formula:
Xr= X max×(1 - N/ Nmax), where
- Xr- the desired level of risk premium associated with the size of the company;
- X max– maximum premium (5%);
- N- the value of the assets of the company being valued according to the balance sheet as of the date of evaluation;
- Nmax- the maximum value of assets among similar enterprises that are engaged in the same types of economic activity.
For example: to determine the risk premium associated with the size of the company for OAO “Subject of Assessment”, the value of total assets of which at the date of assessment was 46,462 million rubles. Information on the value of the assets of similar companies is known: “First analogue” 20,029 million rubles, “Second analogue” 22,760 million rubles, “Third analogue” 51,702 million rubles, “Fourth analogue” 61,859 million rubles .
Solution: The maximum amount of assets among similar enterprises is noted by the Fourth Analogue and amounts to 61,859 million rubles. Then the premium for the risk associated with the size of the company for JSC "Subject of Assessment" according to the presented formula will be
1,2% = 5% * (1- 46 462/ 61 859).
5. How to understand the calculation of the discount rate
Perhaps you have read many textbooks and publications on business valuation and still do not understand the essence of the basic methods for calculating the discount rate. First of all, you are not alone! It is difficult for many to understand these methods, but not many admit it) Good news: knowledge and skills in calculating the discount rate have a very wide scope not only in business valuation, but also in financial management, in evaluating the effectiveness of investments. Therefore, by making efforts to study this issue, you will be rewarded with an increase in your qualifications and professional level)
According to my observations, difficulties in studying the methods of calculating the discount rate may arise with a lack of knowledge in financial management, which discusses in detail the theoretical foundations of the CAPM and WACC models. Therefore, on this topic, I would suggest referring to the fundamental textbooks on financial management by Y. Brigham, Van Horn, etc. Interestingly and a lot has been written about the CAPM model in the book of one of its authors, W. Sharp, “Investments”.
, . .Inflation is defined as the process of an increase in the general (average) price level in the economy, which is equivalent to a decrease in the purchasing power of money. Inflation is called uniform if the rate of general inflation does not depend on time (on the step number of the calculation period). Inflation is called homogeneous if the rate of change in the prices of all goods and services depends only on the step number of the calculation period, but not on the nature of the goods or services. Inflation is said to be constant if its rate does not change over time.
There are two main indicators (parameters) that characterize inflation: the inflation rate and the inflation index. Below we give a definition and give formulas for calculating both indicators (parameters) of inflation.
Inflation is estimated over a certain period of time.
So, to assess inflation at the end of the period in relation to the period, two main indicators are used:
1) the rate (level) of inflation - the relative increase in the average price level in the period under review
2) inflation index (price change index) - an increase in the average price level in the period under review
Relationship between rate and inflation index
The question arises - at what interest rate will the accumulation only compensate for inflation? If we are talking about simple interest, then the minimum allowable (barrier) rate:
For compound interest:
A rate greater than is called a positive interest rate.
The owners of money make various attempts to compensate for the depreciation of money. The most common is the adjustment of the interest rate at which the accumulation is carried out, i.e. an increase in the rate by the amount of the so-called inflationary premium, in other words, the rate is indexed. The final value can be called the gross rate.
Let's discuss methods for determining the gross rate. If we are talking about full compensation for inflation in the amount of the gross rate at , then we find the required value from the equality:
where is the gross rate
From here gross rate for simple interest:
The value of the gross rate for is found from the equality:
From here gross rate for compound interest:
The last formula is called Fisher formula. Sometimes it is also written as:
where i - real interest rate
In practice, the inflation-adjusted rate is often calculated differently, namely:
The last formula, compared to the previous one, contains one additional term, which, if the values are small, can be neglected. If they are significant, then the error (not in favor of the owner of the money) will become very noticeable.
1st cycle - textile factories, industrial use of coal. 2nd cycle - coal mining and ferrous metallurgy, railway construction, steam engine. 3rd cycle - heavy engineering, electric power industry, inorganic chemistry, steel production and electric motors. 4th cycle - production of automobiles and other machines, chemical industry, oil refining and internal combustion engines, mass production. 5th cycle - development of electronics, robotics, computing, laser and telecommunications technology. 6th cycle - perhaps NBIC convergence (convergence of nano-, bio-, information and cognitive technologies). After the 2030s (2050s according to other sources), a technological singularity is possible, which at the moment cannot be analyzed and predicted. Thus, the Kondratiev cycles are likely to end closer to 2030.
18. Equation of exchange by Irving Fisher. Nominal and real interest rates (formula).
Fisher's equation - the equation describing the relationship between tempo inflation, nominal and real interest rates:
where is the nominal interest rate;
Real interest rate;
The rate of inflation.
The equation shows that the nominal interest rate can change for two reasons:
due to changes in the real interest rate;
due to the rate of inflation.
Distinguish between nominal and real interest rates.
Real interest rate- this is interest rate, cleared of inflation.
The relationship between the real, nominal rate and inflation is generally described by the following (approximate) formula:
Nominal interest rate
Real interest rate
Expected or projected rate of inflation.
Irving Fisher proposed a more precise formula for the relationship between the real, nominal rates and inflation, expressed by the Fisher formula named after him:
For and both formulas give the same value. It is easy to see that for small values of the inflation rate, the results differ little, but if inflation is high, then Fisher's formula should be applied.
According to Fisher, the real interest rate should be numerically equal to marginal productivity of capital.
11. The level of cyclical unemployment: the law a. Okun. Economic losses from the operation of the law a. Okun (on the graph of the as curve).
Studies of the relationship between the rate of increase in real GDP and the unemployment rate are expressed in the so-called Okun's law. Okun's Law(the law of the natural rate of unemployment) - if the actual unemployment rate exceeds the natural rate by 1%, then the gap between the actual GDP and the potential one is 2.5% unemployment.
Economic costs - a consequence of the operation of Okun's law - the lag of the actual volume of GDP from its potential volume.
12. Cycle and trend. Characteristics of the phases of the economic cycle.
Business cycles - cyclical changes in the economic environment, regular fluctuations in the level of business activity from economic recovery (boom) to recession (economic depression). Four relatively clearly distinguishable phases are distinguished in business cycles: peak, decline, bottom(or "lowest point") and climb.
Climb occurs after reaching the lowest point of the cycle (bottom). It is characterized by a gradual increase in employment and production. Many economists believe that low inflation rates are inherent in this stage. There is an introduction of innovations in the economy with a short payback period. Demand deferred during the previous recession is realized. 
Peak, or the top of the business cycle, is " highest point» economic recovery. In this phase, unemployment usually reaches its highest low level or disappears completely, production capacities operate at maximum or close to it load, that is, almost all material and labor available in the country are involved in production. resources. Usually, though not always, inflation rises during peaks. The gradual saturation of markets increases competition, which reduces the rate of return and increases the average payback period. The need for long-term lending is growing with a gradual decrease in the ability to repay loans. Recession (recession) is characterized by a reduction in production volumes and a decrease in business and investment activity. As a result, unemployment increases. Officially, the phase of the economic downturn, or recession, is considered to be a fall in business activity that lasts more than three months in a row. Bottom(depression) of the economic cycle is the "trough" of production and employment. It is believed that this phase of the cycle is usually not long.
1The subject of macroeconomics and its place in the structure of the socio-economic formation.
Macroeconomics- studies the functioning of the national economy as a whole. The patterns of development of productive forces and production relations on the scale of the whole society. The objects of research are: gross national product; the national income of society; general price level; employment and unemployment across society; inflation, etc.
Economic theory-science, predstavl. a system of knowledge, cat. describes, explains and predicts the functioning of certain economies. phenomena. John Keynes differentiated the economy into positive (characterized as a positive economy, describes what is in the national economy at the moment) and normative (characteristic of those economic processes and phenomena that should occur in the future)
ME began to develop in the 20-30s of the last century. The author of the term is Ragnar Frisch.
Subject of ME study:
Functioning of the national economy; -analysis of ext. links that unite the entire economy into a single whole; - the inclusion of the national economy in the world.
Subject of study-circulation of resources and funds in the economy-models---:
F. Quesnay's table, 2) K. Marx's reproduction schemes, 3) balance method, 4) system of national accounts.
Methodology for calculating the ME indicators: by total expenses, by total income, by the value added method
Economic growth, 2) price stability, 3) full employment, 4) equilibrium of foreign trade operations, in which exports are equal to imports (“magic quadrangle”)
Fisher's equation
Prices and the amount of money are directly related.
Depending on various conditions, prices may change due to changes in the money supply, but the money supply can also change depending on changes in prices.
The exchange equation looks like this:
Fisher formula
Undoubtedly, this formula is purely theoretical and unsuitable for practical calculations. Fisher's equation does not contain any single solution; within the framework of this model, multivariance is possible. However, under certain tolerances, one thing is certain: The price level depends on the amount of money in circulation. Usually two assumptions are made:
the speed of money turnover is a constant value;
All production capacities on the farm are fully utilized.
The meaning of these assumptions is to eliminate the influence of these quantities on the equality of the right and left sides of the Fisher equation. But even if these two assumptions are met, it cannot be unconditionally asserted that the growth of the money supply is primary, and the rise in prices is secondary. The dependence here is mutual.
In the conditions of stable economic development the money supply acts as a regulator of the price level. But with structural disproportions in the economy, a primary change in prices is also possible, and only then a change in the money supply (Fig. 17).
Normal economic development:
Disproportion economic development:
Rice. 17. Dependence of prices on the money supply in conditions of stability or economic growth
Fisher formula (exchange equation) determines the amount of money used only as a medium of circulation, and since money also performs other functions, the determination of the total need for money involves a significant improvement in the original equation.
The amount of money in circulation
The amount of money in circulation and the total amount of commodity prices are related as follows:
The above formula was proposed by representatives quantitative theory of money. The main conclusion of this theory is that in each country or group of countries (Europe, for example) there must be a certain amount of money corresponding to the volume of its production, trade and income. Only in this case will the price stability. In the case of an inequality in the quantity of money and the volume of prices, changes in the price level occur:
In this way, price stability- the main condition for determining the optimal amount of money in circulation.
QUANTITY THEORY OF MONEY
On the question of the value of money, bourgeois political economy has long been dominated by the quantity theory of money, which asserts that the value of money is inversely related to its quantity.
The founders of the quantitative theory of money were Charles Montesquieu (1689-1755) in France, D. Locke (1671-1729) and D. Hume (1711-1776) in England. Adhering to nominalistic views on the question of the essence of money, the founders of the quantitative theory also saw in metallic money only a sign that did not have intrinsic value; they determined the value of gold and silver money by their number and argued that the more money there is in the country, the higher the commodity prices.
Unlike Montesquieu, who defined the value of money as the quotient of dividing the total amount of money by the total amount of goods, Hume determined the value of money by the ratio between the amount of money in circulation and the mass of goods on the market, believing that goods and money that do not enter into circulation do not affect for prices. The main flaw in the quantity theory of money is the denial of the function of money as a measure of value, in recognizing money as a mere function of a medium of circulation, in fetishizing the latter. Quantitatives believe that all money acquires "purchasing power" as a result of its circulation, and that money allegedly has no value before the process of circulation. K. Marx, criticizing Hume's quantitative theory, wrote:
"In his opinion, commodities enter the circulation process without price, and gold and silver without value."
Representatives of the quantity theory of money mistakenly believe that commodity prices are established in the sphere of circulation as a result of the ratio between the amount of money and goods. In reality, however, commodities are first measured in money as a measure of value and acquire prices, and this happens before they go on sale and come into contact with money as a medium of circulation. The second flaw in the quantity theory of money is the identification of gold and paper money and the extension of the laws of circulation of paper money to gold and silver money.
The third flaw in the quantity theory is the misunderstanding of the relation between the value of money, the prices of commodities, and the quantity of money in circulation. Supporters of this theory argue that the amount of valuable money in circulation does not depend on the conditions of production, prices and value of goods, that any amount of money, even gold, can be in circulation, and that the amount of money determines their value and the price level of goods. K. Marx, showing that the prices of goods do not depend on the amount of money in circulation, but, on the contrary, the amount of full-fledged money necessary for circulation is determined by the level of commodity prices, wrote:
“Thus, prices are not high or low because more or less money is in circulation, but on the contrary, more or less money is in circulation because prices are high or low.”
A special group of supporters of the quantity theory represented by prominent English economists D. Ricardo (1772-1823), James Mill (1773-1836), John Stuart Mill (1806-1873) can be called representatives of the classical quantitative theory of money. They treated money as a commodity without depriving it of intrinsic value.
"...that commodities rise or fall in the chain in proportion to the increase or decrease in the quantity of money, I consider a fact beyond dispute."
D. Ricardo made an attempt to combine the quantity theory of money with the theory of labor value, for which he created the doctrine of the automatic regulation of the amount of gold in circulation by importing and exporting it abroad. According to this theory, net imports of gold or an increase in domestic gold production increase the amount of money in circulation, resulting in a surplus of money in circulation, leading to higher prices and a decrease in the relative value of money. This should lead to an outward flow of gold, causing the money supply to shrink, prices to fall to normal levels, and the relative value of gold to rise.
The failure of this theory lies in the erroneous assumption that all the gold in the country is a medium of exchange. In real life, even under conditions of gold circulation, a part of gold always serves as treasure or world money and is not in the sphere of internal circulation. Ricardo did not understand the economic law governing the amount of money in circulation. According to this law, the amount of valuable money in circulation is always maintained at a level corresponding to the needs of circulation in money, and money that is not needed for circulation is hoarded and goes into treasures. During the period of the general crisis of capitalism, the quantity theory of money, combined with nominalism, is used to justify paper money circulation and the policy of inflation.
A prominent American representative of the so-called new quantitative theory of money I. Fisher (1867-1947) created a mathematical formula for the dependence of the price level on the money supply:
PQ=MV ,
where M is the money supply; V is the velocity of money circulation; Q - the number of circulating goods; P is the level of commodity prices.
Transforming this equation, we get that Fisher determines the level of commodity prices by the formula
P \u003d MV / Q,
those. the product of the mass of banknotes and the speed of their circulation, divided by the number of goods.
Based on this formula, Fisher concludes that the value of money is inversely proportional to its quantity:
“Thus,” the author writes, “from the simple fact that the money spent on goods must equal the quantity of these goods times their prices, it follows that the price level must rise or fall, depending on the change in the quantity of money, if in at the same time there will be no change in the speed of their circulation or in the amount of goods exchanged.
Fisher's "Equation of Exchange" PQ = MV expresses the quantitative relationships between the sum of commodity prices and the circulating money supply; but this equation does not give the right to conclude that the prices of commodities are determined by the amount of money in circulation. On the contrary, the quantity of money in circulation is determined by the prices of commodities, since commodities acquire prices before they enter circulation, and not by virtue of the functioning of money as a medium of circulation, but by virtue of the functioning of money as a measure of value.
The invisible hand of the market in balancing supply and demand
Each person, Adam Smith believed, regardless of the will and consciousness, is directed towards achieving economic benefits for the whole society. Thus, the invisible hand of the market is aimed at obtaining benefits for people. Each manufacturer, for example, strives for its own benefit, but the way to it lies through the satisfaction of the needs of a number of people. This is the whole essence of the principle of the invisible hand of the market: a set of different producers, as if driven by an invisible force, effectively, voluntarily, actively implements the interests of the whole society.
Profit performs a signaling function in the mechanism of the invisible hand of the market and ensures the competent and harmonious distribution of all resources, that is, it balances supply and demand. So, if production is unprofitable, then the amount of resources involved will be reduced. Soon such production will disappear, because the environment of competitors will put pressure on it. The main principle of the invisible hand of the market is that resources are spent on profitable production.
Real Society and the Invisible Hand of the Market: The Problem of Embodiment
And although Adam Smith formulated the principle of the invisible hand of the market correctly, it is difficult to apply it to real economic life. Specific conditions must be taken into account. For example, in the second half of the nineteenth century, tremendous changes took place in the Western European economy. There were enterprises turning into monopolies. This is clearly not included in the model of the invisible hand of the market by all definitions. As a result of the development of technology, enterprises have become dependent on each other. Their ups and downs were simultaneous. Because of this, the market system collapsed, foreseen by Karl Marx. When the process of monopolization of Western markets began to gradually subside, in many industries, companies turned out to be uncompetitive. And today, monopolies in the economy do not interfere with the development of the economy at all, although such a model does not fit the description of the invisible hand mechanism at all.
How does the second hand work?
It turned out that the market also has a "second hand", and it exists much longer than even the "first". Economic relations can also be influenced by status differences between people. At the heart of this principle is the observation not of prices, but of what goods, services and with what effect are sold. Such a “hand” has ruled society since ancient times, but economists simply did not think about it. This is a new manifesto for the development of the market, which implies the provision of product diversity and a high rate of its renewal. By purchasing goods, people try to demonstrate their taste, position in society, that is, they mark their own status. Having understood such mechanisms, it is possible to create a completely new effective market management system in the future.
As Adam Smith noted, it is a remarkable phenomenon in an economy based on private property and free bargaining that market prices subordinate the actions of self-interested people to the prosperity of society or the nation as a whole. The entrepreneur, “driven only by his own benefit,” is nonetheless guided by the “invisible hand” of market prices “towards a goal (namely, the economic prosperity of the country), which was not at all his intention.
Many people find it difficult to understand the law of the "invisible hand" because there is a natural tendency to associate order with central planning. If the task is a reasonable distribution of resources, it seems natural that some branch of the central government should be responsible for this. The law of the "invisible hand" states that this is not necessary at all. With private property and freedom of exchange, prices, forcing millions of consumers, producers and resource suppliers to make their personal choices, are also a means of harmonizing their interests. Prices contain information about consumer preferences, costs and factors related to time, location and other circumstances that neither an individual nor an entire planning body can take into account. Just one single summarizing figure - the market price - provides manufacturers with the full amount of information necessary to bring their personal actions into line with the actions and preferences of others. The market price guides and incentivizes both producers and resource providers to produce the things that are most valued relative to their cost of production.
Business decision makers don't need a central authority to tell them what to produce and how. This function is performed by prices. For example, no one has to force a farmer to grow wheat, to persuade a builder to build houses, or a furniture maker to make chairs. If the prices of these and other commodities indicate that consumers value their value at least at the same level as the cost of their production, entrepreneurs, in pursuit of personal gain, will produce them.
There is also no need for a central authority to control the production methods of enterprises. Farmers, builders, furniture makers and many other manufacturers will seek the best combination of resources and the most efficient organization of production, since lower costs mean higher profits. It is in the interests of every manufacturer to reduce costs and improve quality. Competition practically forces them to do so. It will be difficult for producers with high costs to survive in the market. Consumers looking to make the most of their money will see to it.
The "invisible hand" of the market process works so automatically that most people don't even think about it. They simply take it for granted that goods are produced in roughly the quantities that consumers want to purchase them. The long queues that characterize centrally planned economies are virtually unfamiliar to people living in a market economy. The availability of a huge variety of products that strikes the imagination of even modern consumers is also largely taken for granted. The "invisible hand" creates order, harmony and variety. This process, however, goes so latently that few people understand its essence, and only a few do it justice. However, it is decisive for the economic well-being of society.
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The theory of unemployment by the English economist J. M. Keynes, which can be called the theory of insufficient demand, has the greatest distribution in modern bourgeois political economy. According to Keynes, "the volume of employment is in a very definite way related to the volume of effective demand", and the presence of "underemployment", i.e. unemployment, is due to the limited demand for goods.
Keynes derives the insufficiency of consumer demand from the properties of human psychology, stating that the propensity to consume decreases with increasing income. According to him, as their income grows, people spend less and less of it on consumption and save more and more, and the decrease in the propensity to consume is supposedly an eternal psychological law.
“The psychology of society,” argues Keynes, “is such that as aggregate real income increases, aggregate consumption also increases, but not to the same extent as income increases.”
Keynes explains the lack of demand for the means of production by the weakness of the "stimulus to investment." This "incentive to invest" depends, in his opinion, on many factors: on what income the capitalist expects to receive as a result of investments, on whether he believes in the reliability of investments or considers them risky, whether he evaluates economic, optimistic or pessimistic social and political perspectives, etc. Here Keynes also assigns the main role to psychological moments.
Keynes attaches particular importance to the level of lending interest. He argues that the level of interest is the regulator of the amount of investment and that the higher the rate of interest, the less incentive for entrepreneurs to invest. The rate of interest, according to Keynes, is too high under modern capitalism, which slows down investment and thus leads to high unemployment.
Acting, in the witty expression of William Foster, as an emergency physician in sick capitalism, Keynes argues that unemployment is such a disease of modern capitalism that it is completely curable if only the right medicines are applied.
“It is clear,” wrote Keynes, “that the world will no longer tolerate the unemployment which, except for short periods of excitement, accompanies and, in my opinion, inevitably accompanies modern capitalist individualism. However, with the help of a correct analysis of the problem, it is possible to cure the disease and at the same time preserve efficiency and freedom, that is, to destroy unemployment while maintaining capitalism, which Keynes considers synonymous with "efficiency and freedom."
To eliminate unemployment under capitalism, according to Keynes, it is necessary to increase government spending, which supposedly can compensate for the insufficient propensity to consume individuals and bring the total amount of effective demand to a level that ensures "full employment". He further considers it necessary to stimulate investment by lowering the rate of interest, for which the state and central banks should increase the issuance of paper money or fiat banknotes. Keynes's doctrine found numerous followers: in England - V. Beveridge, J. Robinson and others, in the USA - E. Hansen,
S. Harris and others, as well as in other capitalist countries. Keynesians also proceed from the position of the determining role of market demand. For example, according to E. Hansen, "the only thing missing before the war, the only thing the American economy needs, is sufficient aggregate demand"
Calling the problem of supplying such demand "the most important problem," Hansen writes:
"You cannot rely on the private economy to generate sufficient energy on its own to provide full employment."
Therefore, he advocates an increase in government spending as a way to ensure full employment. Noting the "tremendous increase in the government's financial operations," Hansen states that "this is precisely the Chinese remedy for stagnation," a means of ensuring sufficient aggregate demand and full employment.
Regulation of the amount of money in circulation and the price level is one of the main methods of influencing the economy.
The relationship between the quantity of money and the price level was formulated by representatives of the quantity theory of money.
In a free market () it is necessary to regulate economic processes to a certain extent (Keynesian model). The regulation of economic processes is carried out, as a rule, either by the state or by specialized bodies. As the practice of the 20th century has shown, many other important economic parameters depend on the one used in the economy, primarily the price level and interest rate (credit prices). The relationship between the price level and the amount of money in circulation was clearly formulated within the framework of the quantity theory of money.
Fisher's equation
Prices and the amount of money are directly related.
Depending on various conditions, prices may change due to changes in the money supply, but the money supply can also change depending on changes in prices.
The exchange equation looks like this:
Fisher formula
Undoubtedly, this formula is purely theoretical and unsuitable for practical calculations. Fisher's equation does not contain any single solution; within the framework of this model, multivariance is possible. However, under certain tolerances, one thing is certain: The price level depends on the amount of money in circulation. Usually two assumptions are made:
- the rate of money turnover is a constant value;
- All production capacities on the farm are fully utilized.
The meaning of these assumptions is to eliminate the influence of these quantities on the equality of the right and left sides of the Fisher equation. But even if these two assumptions are met, it cannot be unconditionally asserted that the growth of the money supply is primary, and the rise in prices is secondary. The dependence here is mutual.
In the conditions of stable economic development the money supply acts as a regulator of the price level. But with structural disproportions in the economy, a primary change in prices is also possible, and only then a change in the money supply (Fig. 17).
Normal economic development:
Disproportion of economic development:
Fisher formula (exchange equation) determines the amount of money used only as a medium of circulation, and since money also performs other functions, the determination of the total need for money involves a significant improvement in the original equation.
The amount of money in circulation
The amount of money in circulation and the total amount of commodity prices are related as follows:The above formula was proposed by representatives quantitative theory of money. The main conclusion of this theory is that in each country or group of countries (Europe, for example) there must be a certain amount of money corresponding to the volume of its production, trade and income. Only in this case will the price stability. In the case of an inequality in the quantity of money and the volume of prices, changes in the price level occur:
In this way, price stability- the main condition for determining the optimal amount of money in circulation.