MODI, S. A. (2011) Commodity Price Characteristics and Economics of Gold Price Movements. University of Nottingham.

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UNIVERSITY OF NOTTINGHAM • MSc FINANCE & INVESTMENT • SEPTEMBER 2011
Commodity Price Characteristics And
The Economics of Gold Price Movements
Shripal Alkesh Modi
Student ID: 4149469
2011
ABSTRACT
To understand the economics of daily gold price data for five years from 2006 to
2011, a linear regression log-log model is developed to establish the correlation
relationship of some of the most relevant macro-economic variables affecting
gold price. Empirical results showed predicted correlation relationships as in
previous literature, and the high significance levels suggest that the movements
of gold price is highly correlated with the drivers during a recession, thus
suggesting that gold is considered as a crisis hedge. The demand and supply
factors were also explored, alongside evaluating commodity and gold price
characteristics of convenience yield and mean reversion. Finally, Monte-Carlo
simulation using gBm was undertaken to simulate future gold price movements.
A Dissertation Presented in Part Consideration for the Degree of “MSc Finance & Investment”

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Acknowledgement
The subject of gold and its prices has been a close topic to my family’s heart, due to the cultural
and traditional importance it holds within our lives. It is also the area of business of my family
for many years now, and the price fluctuations and volatility is a regular topic of conversation
over dinner tables.
Through this paper, I have been able to extend my basic and most fundamental knowledge
about the gold market and understand the greater complexities that cause gold price
fluctuations and volatility through elaborate background research and empirical analysis of gold
price data. This would have not been possible without the undying support, love and
encouragement of my parents and brother, and I would like to sincerely thank them for
supporting me.
I would also like to express my most sincere thanks and gratitude to my supervisor, Mr. Scott
Goddard, for his much-valued guidance and direction. Throughout the process of writing this
paper, he has been more as a friend than supervisor, and the support has been very encouraging
and constructive towards the final outcome of this paper.
And finally, it wouldn’t be appropriate if I didn’t thank my dear friend, Miss Zlatina Gyurova, for
her help and support during my study here at the University of Nottingham. Her ideas and
concepts have always challenged they way I approach my work in the most positive manner,
and this has been very beneficial to my work approach and life.

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Contents
Acknowledgement 2
Tables and Figures 6
1. Introduction 8
1.1 The Commodity Market 8
1.2 Gold Price 8
1.3 Areas of Research 9
1.4 Structure of the Dissertation 10
2. Commodity Price Characteristics 11
2.1 Commodity Spot Trading 11
2.2 Theory of Storage, Inventory and Convenience Yield 13
2.3 Empirical Evidence on the Theory 14
2.4 Mean Reversion in Commodity Prices 15
2.5 Summary 16
3. Gold and Price Economics 17
3.1 History of Gold 17
3.2 The Gold Standard 18
3.3 The Present Monetary Policy 20
3.4 Gold Price Evolution 20
3.5 Price Economics and Descriptive Analysis 22
3.6 Summary 26

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4. The Demand for Gold 27
4.1 Introduction to Gold Demand 27
4.2 Demand for Ornamentation 28
4.3 Hoarding and Investment Demand 30
4.4 Industrial and Dental Demand 31
5. The Supply of Gold 33
5.1 Introduction to Gold Supply 33
5.2 Mine Production 34
5.3 Recycled Gold – Old Gold Scrap 36
5.4 The Central Banks 37
6. Factors Influencing Gold Price 38
6.1 Literature Review 38
6.2 The US Dollar and Price of Gold 41
6.3 Inflation Effects 45
6.4 Interest Rate Effects 49
6.5 The US Stock Index and Financial Market 51
6.6 Oil Prices and Effects on Gold Price 55
7. Methodology 59
7.1 Dissertation Objectives Research Strategy 59
7.2 Data 61
7.3 OLS Estimators 62
7.4 Tests for Serial Correlation and AR Process 63
7.5 Stationarity and Unit-Root Test 66
7.6 Price Modelling 69

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8. Empirical Findings and Analysis 71
8.1 Serial Correlation 71
8.2 Error Correction Model 73
8.3 Coefficients Analysis 75
8.4 Unit Root and Price Modelling 78
9. Evaluation 85
9.1 Areas for Further Research 85
10. Conclusion 86
11. References 88
12. Appendix 100
12.1 Appendix A - Key Descriptive Analysis 100
12.2 Appendix B - Global Gold Demand in Tonnes 101
12.3 Appendix C – Global Gold Supply in Tonnes 102
12.4 Appendix D – World Gold Production – 20 Years (Tonnes) 103
12.5 Appendix E –Daily USD to Chinese Yuan Exchange Rate; with Gold Price 104
12.6 Appendix F–Monthly US Annual Inflation Rate; with Gold Price 105
12.7 Appendix G – Monthly US Monetary Base 106
12.8 Appendix H – Daily 6 Month T-Bill Middle Rate; with Gold Price 107
12.9 Appendix I – Daily S&P500 Index with Gold Price; Gold Price/S&P 500 Ratio 108
12.10 Appendix J – Standard Regression Model Output & Durbin-Watson d-Statistic 109
12.11 Appendix K – Auxiliary Regression Model Output & LM Statistic AR(2) Order 110
12.12 Appendix L – Complete Prais-Winsten Regression Output 111
12.13 Appendix M – ADF Test Results 112

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Tables and Figures
List of Tables
Table 3.1: Data Analysis of Gold Price Returns
Table 5.1: World Gold Production (Tonnes)
Table 5.2: Gold Supply – Recycled and Total (Tonnes)
Table 5.3: Summary of World Official Gold Holdings, August 2011
Table 7.1: Data Variables and Primary Source
Table 8.1: d-statistic and Critical Values at 5% and 1% Significance Levels
Table 8.2: Breusch-Godfrey LM Test Results (Sept ’06 to Aug ’11)
Table 8.3: Prais-Winsten Regression Output (Sept ’06 – Aug ’11)
Table 8.4: ADF Unit-Root Test Results for (log) Price of Gold(Daily; Aug ’06-Aug ’11)
Table 8.5: PP Unit-Root Test Results for (log) Price of Gold (Daily; Aug ’06-Aug ’11)

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List of Figures
Figure 2.1: Evolution of Price of Crude Oil-Brent Dated FOB (Daily; 1982-2011) – USD/Barrel
Figure 2.2: Mean Reversion
Figure 3.1: Evolution of Price of Gold Bullion (Daily; 1968-2011) – USD/Troy Ounce
Figure 3.2: Evolution of Price of Gold Bullion (Daily; Aug ’06 – Aug ‘11) – USD/Troy Ounce
Figure 3.3: Gold Price (log) Returns (Daily; Aug’06 – Aug ’11)
Figure 3.4: Gold Price Rolling 22-Day Annualised Volatility (Aug ’06 – Aug ’11)
Figure 4.1: Demand Flows: 5-Year Average (Q4, 2005 – Q3, 2010)
Figure 4.2: Annual Demand for Gold (tonnes) 10 year average (1996-2005)
Figure 4.3: Gold Demand (Volume) and Gold Price (USD/Troy Ounce)
Figure 5.1: Supply Flows: 5-Year Average (Q4, 2005 – Q3, 2010)
Figure 5.2: Above-Ground Stocks, End of 2009 (165,600 Tonnes)
Figure 6.1: Chinese Yuan to US Dollar Exchange Rate; with Gold Price (Daily; Aug ‘06 – Aug ’11)
Figure 6.2: US Consumer Price Index; with Gold Price (Monthly; 1968-2011)
Figure 6.3: Nominal vs. Real Gold Price (Monthly; 1968-2011) – USD Troy Ounce
Figure 6.4: US Annual Inflation Rate; with Gold Price (Monthly: Aug ’06 – Aug ’11)
Figure 6.5: 6M T-Bill Rate; with Gold Price (Daily; Aug ‘06 – Aug ’11)
Figure 6.6: S&P 500 Index; with Gold Price (Daily: 1968-2011)
Figure 6.7: Gold Price (Ounce) to S&P 500 Index Ratio (Daily: Aug ’06-Aug ’11)
Figure 6.8: Crude Oil Price; with Gold Price (Daily; Aug ’06-Aug ’11)
Figure 6.9: Gold Price (Ounce) to Crude Oil (Barrel) Ratio (Daily: Aug ’06-Aug ’11)
Figure 8.1: gBm Simulation of Gold Bullion Price (Daily; Aug ’11 to Aug ’12)
Figure 8.2: gBm Simulation vs. Actual Price of Gold Bullion Price (Daily; Aug ’10 – Aug ‘11)
Figure 8.3: gBm Simulation vs. Actual Price of Gold Bullion Price (Daily; Aug ’05 – Aug ‘06)

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1. Introduction
1.1 The Commodity Market
OVERVIEW
The commodity market has always garnered large amounts of interest from the investing world
due to the unique characteristics of the various commodities traded. A commodity, by nature, is
a resource or an asset that is demanded for consumption, but whose supply is limited due to the
depleting resources of the world. Gamen (2005) defines a commodity from the viewpoint of
different occupations. As an economist, the demand and exhausting underground reserves
(supply) of commodities is considered to have a major impact on the world and the country-
specific economic development (para. 2).
Commodity resources include metals such as copper, aluminium, zinc, etc.; precious metals such
as gold and silver in bullion and coins; agricultural commodities such as grains, coffee, cotton,
sugar, orange juice; and livestock; and energy commodities such as oil, gas and electricity.
Commodity prices have seen major fluctuations over recent years due to the dramatic changes
in world commodity markets, and the factors affecting commodity price movements are
explored in this paper.
1.2 Gold Price
With an extensive history surrounding gold that dates back to around 3600 BC when Egyptian
goldsmiths carried out the first smelting of gold to separate it from other metals, to 2011 AD
where gold is used for the first time in automotive emissions control in catalytic convertors by a
European diesel car manufacturer, gold has played an essential role within the human society,
and has contributed to its progress. However, in recent times, gold prices have hit record-level

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highs, and there have been significant debates regarding investments in gold as a hedge against
bear or poor performing markets. The BBC reported that gold is seen as a safe investment and
often rises in times of uncertainty (BBC, 2011) and on July 25, 2011 BBC news headlined gold
prices hitting a record new high of USD 1,615 an ounce due to growing concerns regarding the
debt-ceiling agreement by the US Congress.
This paper deals with the recently-rising prices of gold, which is one of the most precious metals
naturally available. It also attempts to understand the gold price economics in relation to
several key dependant macro-economic factors during times of economic instability.
Note that gold is a very unique commodity and is used not only as short and long term
investment by investors, financial institutions and governments, but also for personal
consumption. It also has several other desirable properties and usages, and these characteristics
are discussed in chapters 2 & 3. This paper also dwells into gold’s extensive and sometimes
magical history.
1.3 Areas of Research
PURPOSE AND RESEARCH OBJECTIVES
The research objectives are laid out in a specific list in this section to understand the purpose of
this paper in greater detail. Over the course of this paper, it will attempt to evaluate the nature
of gold prices in a concise manner, and achieve the objectives with the help of past theory and
empirical research. This will assist in systematically understanding the research question.
The research objectives are as follows:
a. Understand the commodity spot market, its components and drivers of commodity
prices.
b. Consider the characteristics of commodity prices, and seek to understand how these
characteristics differ from other investment instruments such as equities.
c. Investigate the history of gold, its importance within the human society, and the role
of the gold standard on monetary policies of various countries.
d. Identify the behaviour and economics in gold price movements through
understanding its risk and return properties.
e. Identify demand and supply sources of gold across the world, and its effect on prices.

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f. Critically evaluate the most suitable macro-economic factors that contribute to the
fluctuations in prices of gold.
g. State the most suitable means of understanding the price data, and explicitly state
how empirical analysis will be undertaken.
h. Evaluate the nature of time series data, to help formulate a regression process.
i. Compute and critically analyse the findings to answer the research question with the
use of appropriate figures and tables.
j. Understand the importance of further developing this piece of research for future
attempts on this topic.
k. Critically reflect, and conclude.
1.4 Structure of the Dissertation
The rest of this paper is organised as follows. Chapter 2 evaluates the commodity spot market
and commodity characteristics to provide a brief overview of the investment instrument, i.e.
gold bullion. Chapter 3 attempts to deal with gold’s glorious history, its influence on the world
monetary systems, and evaluates the daily price and return characteristics. Chapters 4 & 5 deal
with gold demand and supply respectively. Chapter 6 evaluates the macro-economic factors
affecting gold price, and explores past literature and empirical studies.
After concluding the literature review, chapter 7 draws the methodology required to undertake
empirical analysis. A summary of the findings and relevant analysis from the empirical research
has been stated in chapter 8 to understand the economics of gold price. The areas of further
research have been outlined in chapter 9, and this paper has been concluded in chapter 10
through summarising the most important findings from the literature review and empirical
research.
An exhaustive list of appendices has also been provided at the end of this paper for further
references.

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2. Commodity Price Characteristics
2.1 Commodity Spot Trading
SPOT-TRADING
Commodities are traded on the spot market in order to maintain a highly standardised process
over the quality, quantity and delivery dates. One of the first commodity exchanges was set up
in 1842 with the establishment of the New York Cotton Exchange (NYCE). This was followed by
the establishment of the Chicago Board of Trade (CBOT) in 1848 and the London Metal
Exchange (LME) in 1877 after merchants started trading their goods and produces in forward
transactions. These are only a few of the boards or indices that were established to regulate the
commodities industry, and many more have originated since.
Transactions of any nature within the commodity market may either be physical, where there is
delivery of the commodity, or purely financial, where there is no exchange of the underlying
commodity but only a transfer of cash between the concerned parties. Commodity spot trading
poses four major types of risk. They are price risk; transportation of the commodity risk which
may include war, riots and strikes; delivery risk; and credit risk which is prevalent throughout
the transaction until completion.
THE CURRENT COMMODITY MARKET OVERVIEW
Commodity prices are often characterised by extremely high levels of volatility (Newbery &
Stiglitz, 1981; Deaton & Laroque, 1992; Myers, 1994; Pindyck, 2001; Gamen, 2005), due to the
different forces influencing different commodity prices. Within recent times, the prices of
commodities have remained largely volatile and have exploded due to various market forces
acting collectively, particularly in the case of precious metals such as gold and silver, where
prices have sky-rocketed due to low interest rates and the ‘misaligned’ exchange rates.
Commodity prices have also risen due to high inflation levels and political and economical
instability within several regions. The depreciating value of the US Dollar has contributed to

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increased prices of primary commodities such as wheat and corn. A surge in population and
increasing consumption levels due to the emergence of new superpowers such as China, India
and Brazil have also contributed to the high price and supply volatility within the agricultural
commodities market. In India, food prices have reached record levels over recent months due to
soaring inflation and ever-growing demand.
Crude oil is one of the most essential commodities and its prices had hit a record level of USD
147 per barrel (see figure 2.1) before the 2007-08 recession, after which the prices started to
collapse dramatically. However, political uprising and economic tensions within the middle-east
region has threatened an oil price increase again. Overall, the outlook for commodity markets
looks very volatile under current economic policies.
Figure 2.1: Evolution of Price of Crude Oil-Brent Dated FOB (Daily; 1982-2011) – USD/Barrel
Source: ICIS Pricing.
In the following sections within this chapter, this paper explores the theory of storage and the
concept of convenience yield among spot and future prices. It attempts to understand its
implications of this theory on prices through previous empirical research. The commodity price
characteristics of mean reversion have also been highlighted.
0255075100125150
CrudeOilBrentPrice-USD/BBL
Jan 82 Sep 85Sep 85 May 89 Feb 93 Oct 96 Jul 00 Mar 04 Nov 07 Aug 11
Timeline

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2.2 Theory of Storage, Inventory and Convenience Yield
SPOT AND FUTURE PRICES
The theory of storage, the level of inventory or stock, the global production levels, the natural
resource levels, and the convenience yield factor are important determinants in establishing
spot and future prices of commodities. Hull (2009) explains that convenience yield reflects the
market’s expectations concerning the future availability of the commodity. The greater the
possibility that shortages will occur, the higher is the convenience yield (p. 118).
For a storable commodity, the future price ˦ {ˮ{1 is the spot price ˟{ˮ{ multiplied by the
continuously compounding interest (r) and convenience yield (y) rate over time (T-t).
˦ {ˮ{ = ˟{ˮ{˥{ {{ {
............... (1)
Inventories help organisations keep their costs down by providing for regular supplies and
deliveries through fluctuating market conditions. However, when factoring for spot and future
prices of commodities, this cost of storage and the accompanying benefits of holding the
commodity are taken into account. This advantage of holding the commodity has been widely
debated, and Brennan (1958) and Telser (1958) view the convenience yield as an embedding
timing option attached to the commodity since inventory allows us to put a commodity on the
market when the market prices are high and hold it when prices are low (Geman, 2005, p. 25).
Gibson & Schwartz (1990) suggest that the notion of convenience yield, viewed as a net dividend
yield accruing to the owner of the physical commodity at the margin, has already proven to drive
the relationship between futures and spot prices of many commodities (p. 959).
For storable commodities such as gold, other metals and oil, the convenience yield is in a one-to-
one relationship with the shape of the forward curve, the value of the spot price (or nearby future),
thus indicating whether the whole curve is located at a high level or low level (Geman, 2005, p.
39). Telser (1958), Brennan (1958) and Williams (1986) among many others assert that
processors and consumers of a commodity receive a stream of implicit benefits when they hold
inventories of the good, which they refer to as the ‘convenience yield’ (Ng & Pirrong, 1994, p.
206). Hence, higher the price volatility of commodities, the greater is the convenience yield.
1
This equation contributes to very high correlation between commodity spot and forward prices.

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2.3 Empirical Evidence on the Theory
INVENTORY LEVELS AND PRICES
Inventory levels have proven to have a direct impact on future prices of commodities.
Samuelson’s hypothesis (1965) undertook extensive research in the field of understanding
future and sport price variations based on inventory levels. Samuelson’s hypothesis stated that
spot prices are more volatile than forward prices. This hypothesis holds true when the
inventory is low, as highlighted in the research paper by Fama & French (1988), where they
statistically analysed price volatility in relation to commodity inventory levels. Fama & French
highlighted the effect of positive demand shocks, providing evidence that metal production does
not adjust quickly, and as a consequence, inventories fall, forward prices are below spot price, and
concluded that spot prices are more variable than forward prices around business cycle peaks, all
in the manner predicted by the theory of storage (p. 1076 & p. 1092). On the other hand, high
inventory causes an almost perfect correlation between changes in spot and forward prices
because the theory of storage predicts that large inventory responses to shock imply roughly
equal changes in current and expected spot prices (1988, p. 1092).
Ng & Pirrong (1994) conducted their own empirical analysis similar to Fama & French (1988) to
understand the dynamics of metal prices and volatility between spot and future prices. The
paper conducted separate tests and indicated evidence that the marginal value of convenience
yield declines as inventory rises and also goes on to suggest that the convenience yield is a convex
function of stocks (p. 206)2. This is particularly evident in the case of industrial metals where
they support the theory that spot-and-forward return dynamics are strongly related to the
variations in fundamental supply and demand conditions (p. 228).
However, for precious metal such as silver which was also tested for price volatilities, the theory
of storage, as predicted, does not hold. Fama & French (1988) suggest that the storage costs for
precious metals are low relative to their value because of the demand for gold and silver as
investments assets, and this leads to inventories sufficient to limit variation in convenience yields
(p. 1084). Precious metals like gold and silver are primarily held for their value over time,
unlike other industrial metals. Stock outs and convenience considerations are largely irrelevant
for silver (Ng & Pirrong, 1994, p. 228), and hence, prices of precious metals are not affected as
much as other industrial metals post production and processing.
2
Refer to Ng &Pirrong (1994 p. 207) for convex convenience yield figure.

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2.4 Mean Reversion in Commodity Prices
Commodity prices do not exhibit the same price properties as stocks, where over time, stock
prices tend to grow.
Literature on commodity prices have repeatedly suggested that commodity prices follow mean-
reversion i.e. over a period of time when price are too high (low), demand will reduce (increase)
and supply will increase (reduce), bringing about equilibrium (see figure 2.2). Geman (2005)
suggests that even if sharp rises are observed during short periods for specific events, such as the
weather or political conditions in producing countries, commodity prices tend to revert to ‘normal
levels’ over a long period (p. 52). This is in contrast to stock prices, which grows on average over
time because the investor is rewarded for the time value of his money augmented by a risk
premium (p. 52).
Figure 2.2: Mean Reversion
Source: Hull, 2009, p. 683.
Lutz (2010) suggests that mean reversion is mainly induced by convenience yields (p. 9) and this
paper seeks to understand the existence of mean reversion on asset prices. Casassus & Collin-
Dufresne (2005) undertook empirical research to understand the relationship between
convenience yield margins and mean reversion levels in commodity prices of crude oil, copper,
Time
Reversion Level
Commodity
Price High commodity prices have negative trend
(low demand)
Low commodity prices have positive trend
(High Demand)

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silver and gold. The findings conclude that copper has a very similar behaviour to crude oil, and
that there is significant positive relation between the spot price of copper and its convenience yield
(p. 2304), thus implying strong mean reversion in spot prices for these two commodities. This is
in line with the predictions of the theory of storage, and similar findings were earlier
demonstrated by Ng & Pirrong (1994).
However for gold and silver, Casassus & Collin-Dufresne (2005) conclude that there is negligible
relationship between the convenience yield and spot prices, suggesting the lack of mean
reversion properties amongst precious metals.
2.5 Summary
Previous researches have shown that general commodity price characteristics do not hold true
for precious metals in the same manner as other commodities and metals. There are also doubts
over the mean reversion properties among prices of precious metals. Hence, the question is, are
precious metals such as gold and silver to be treated as commodities, or can they be treated as
equity-type securities, who serves the purpose of investment and return over time when
undertaking price modelling?
As shown by Fama & French (1988), and Ng & Pirrong (1994), the theory of storage has little
effect on the prices of precious metals, and Casassus & Collin-Dufresne (2005) highlight the lack
of mean reversion properties. But does this factor affect the pricing model for precious metals
such as gold and silver? As most previous literature that attempts to model commodity prices
takes into account the mean reversion properties of commodity prices, this paper will similarly
explore the commodity characteristics of mean reversion when modelling gold prices by
systematically incorporating stationarity tests and testing for existence of unit-root among gold
prices.

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3. Gold and Price Economics
3.1 History of Gold
“Held securely in national vaults as a reserve asset, gold has an irrefutable logic;
released from the tombs of pharaohs and emperors alike, gold has an
undeniable magic” (World Gold Council, 2011).
OVERVIEW
As rich as gold is in appearance and social position, its history is even more complex. If ever
there was a better description summarising the importance of gold, it has been acutely
portrayed by the World Gold Council (WGC), 2011 by stating that wars have been fought for it
and love has been declared with it for its brilliance. Bernstein (2000) suggests that gold endures a
standard of value and from the Golden Rule to the Olympic Gold; it has commanded far more
respect than any other substance in history (p. 20).
HERITAGE AND HISTORY
Once gold had been discovered during the early civilisation, it has been used for numerous
different purposes. Back in 2600 BC, goldsmiths of ancient Mesopotamia (modern-day Iraq) had
began to craft the earliest known pieces of gold jewellery, a burial headdress of lapis and
carnelian beads with willow leaf-shaped gold pendants (WGC, 2011). Ancient archaeological
discoveries have been made where Egyptians liken gold to the powers and brilliance of the sun,
whom they worship. Tombs beneath the great pyramids in Egypt have revealed that gold was
extensively used to beautify the royals post their death. Famously in 1223 BC, gold was used to
create Tutankhamun’s funeral mask in ancient Egypt which is considered as a masterpiece of
craftsmanship from the years gone by. It is also one of the most iconic funeral masks created out
of gold, and has attained international recognition. Around 564 BC, gold was first used as

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standardised currency for trade, because gold jewellery was already widely accepted and
recognised throughout various corners of the earth and that the creation of a gold coin stamped
with a seal seemed to be the answer (Balarie, 2008).
MODERN USAGE
Gold had maintained its prominent standing within the human society into the modern age. As
Balarie (2008) suggested, gold symbolised wealth throughout Europe, Asia, Africa and the
Americas. Gold’s durability, density, and glow made it a natural choice as a store of wealth long
before people thought about it as money (Bernstein, 2000, p. 23). Eventually, in 1717 AD, UK was
the first country to establish the gold standard through linking the currency to the value of gold
at a mint price of seventy-seven shillings, ten and a half pennies per ounce of gold (WGC, 2011).
And soon after from around 1840 to 1900 AD, most other countries began adopting the gold
standard. In between this, California and South Africa encountered the gold rush after
accidently discovering large deposits of gold ores.
After playing a major role in establishing how our financial and monetary system work, the
modern usage of gold varies greatly, from electrical wires in high end audio and video products
to using it in heart surgeries. However, a majority of the gold is still used for either private
investment purposes, or for the jewellery industry, or as reserves for national banks to protect
and safeguard the economy’s future.
3.2 The Gold Standard
HISTORY OF THE INTERNATIONAL GOLD STANDARD
The gold standard played a prominent role in determining the price of gold in today’s world.
Whereas Britain was the first nation to adopt the gold standard back in 1717, other
participating countries did not adopt the gold standard system immediately. In fact, the
discoveries of large deposits of gold ores and fears of inflation deterred other nations to adopt
this system until the latter half of the nineteenth century (Sayers, 1933). This fear by some
nations is also highlighted by Eichengreen & Flandreau (1997), stating that the possibility of
inflation due to newly mined gold flowing into the coffers of central banks led governments to

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suspend the gold coinage (p. 6). The fears of inflation never materialised in the end, but it is
critical to analyse the role of inflation within the economy and its effects on gold price, which
was the basis of monetary policy in the late nineteenth and early twentieth century.
The United States adopted the gold de facto in 1834, where it set the price of gold to USD 20.67
per troy ounce, a price that remained till 1934 (Bordo, 2008). However, the gold standard was
abolished during the unfortunate events of World War One. Post the Great War though; the gold
standard was briefly reinstated from 1925 to 1931 as the Gold Exchange Standard after the
agreement at the International Economic Conference held at Genoa, 1922. In a few words that
summarises the desire to bring about the swift return of gold, it declared:
“An essential requisite for the economic reconstruction of Europe is the
achievement by each country of stability in the value of its currency... It is
desirable that all European currencies should be based upon a common
standard...Gold is the only common standard which all European countries
could at present agree to adopt...” (Kemmerer, 1944, p. 110).
Under the Gold Exchange Standard, countries could hold gold or dollars or pounds as reserves,
except for the United States and the United Kingdom, which held reserves only in gold (Bordo,
2008). The UK returned to the gold standard at pre-war parity and a fixed exchange rate of USD
4.86 = GBP 1.00 (WGC, 2011), and because the exchange rate were fixed, this caused the gold
prices to move together across the world.
This version broke down in 1931 following Britain’s departure from gold in the face of massive
gold and capital outflows. Other countries followed suit, and this was attributed to the world
economic crisis of the early thirties that did not allow the new gold exchange standard to be
perfected and firmly establish itself(Kemmerer, 1944, p. 120).
Then in 1933, something very extraordinary happened. President Franklin D. Roosevelt
suspended gold and the US dollar convertibility to gold at USD 20.67 per troy ounce. Gold was
nationalised and possession of gold was prohibited. Alongside, all contracts specified in gold
were terminated. Having seized most of the gold from the public and safely deposited in the
government reserves, the dollar was made convertible again in January 1934 at a new price of
USD 35.00 per troy ounce, increasing the value of US gold reserves by 69.3%.

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3.3 The Present Monetary Policy
Towards the end of the Second World War, the Bretton Woods conference held in 1944 set the
basis of the post-war monetary system, maintaining the US Dollar at a set rate of USD 35.00 = 1
oz (ounce) gold conversion rate. The other currencies were fixed in terms of the US dollar, thus
forming a Gold Exchange Standard. This policy assured long-term price stability, but because
economies under the gold standard were so vulnerable to real and monetary shocks, prices were
highly unstable in the short run (Bordo, 2008).
The rush for gold by private speculators also was heating up and it became increasingly difficult
to fix and maintain the gold price at USD 35.00. In 1967, William McChesney Martin of the US
Federal Reserve Board rashly suggested that it would defend the $35 price ‘to the last ingot’
(Green, 1993, p. 51). The bluff was called and the pressure mounted after 3,000 tonnes of gold
was lost to speculative investors and others. Eventually, the gold standard under the Bretton
Woods system of fixed exchange rates was brought to an end by President Richard Nixon
through suspending the ‘gold window’ of US dollar convertibility to gold. The price was no
longer set and the world entered its present day system of floating exchange rates.
The gold market, as it is now, represents a substantial and efficient financial asset market
(Tschoegl, 1980), and numerous countries deal within it on a continuous basis due to the types
of market (physical, futures, and options on futures and on the physical) available.
3.4 Gold Price Evolution
HISTORICAL PRICE ANALYSIS
Figure 3.1 depicts the evolution of the daily gold price on the London Bullion Market (LBM) in
USD/troy ounce for a period from January 1968 to August 2011, spanning approximately 43
years.
The price range of our data over the sample period varies from between USD 34.83 which was
recorded on the January 28, 1970, and USD 1678.45, which was achieved on August 4th, 2011,
following the news of President Obama signing the US debt ceiling bill on August 2, 2011.

21
Evaluating the gold price from around the post Bretton Woods era back in 1968, gold price was
at USD 35.16/troy ounce, and it remained stable at or around that price region until 1972,
reaching a high of USD 43.60/troy ounce at the end of April, 1969. However, since 1972, gold
prices started to see increased volatility after it was floated on the market. This price volatility
and rapid increase until 1974 was put down as a direct response to the long period in which gold
had been artificially held down, and also to the absence of additional new mining supply, alongside
the oil shock of 1973(Mills, 2004, p. 560).
Figure 3.1: Evolution of Price of Gold Bullion(Daily; 1968-2011) – USD/Troy Ounce
Source: London Bullion Market.
Gold prices also rose rapidly from September 1976 onwards to January 1980, when gold prices
hit a high of USD 835/troy ounce due to high inflation and the loss of confidence in the US Dollar
value, highlighting the lack of trust in the US government and paper money. During this crisis,
the issue of the Business Week magazine on March 12, 1979 headlined its cover ‘The Decline of U.S.
Power’ (Bernstein, 2000, p. 356). However, this rise didn’t last long, and prices started to decline
almost immediately and settled at around the USD 300/troy ounce by 1982, and fluctuated
around the USD 400/troy ounce mark until 1985.Eventually, gold prices started to settle due to
stable valuation of the US Dollar over longer periods.
0300600900120015001800
GoldBullionPrice-USD/TroyOunce
1968 1972 1976 1981 1985 1989 1994 1998 2002 2007 2011
Timeline

22
Gold prices did rise, but only briefly during the ‘Black Monday’ stock market crash in 1987. The
average price of gold between 1987 and 2002 was USD 352.29/troy ounce, and ranging
between USD 252.85 and USD 502.75.
Post 2002, gold prices rose on an average annual basis of approximately 18%, from USD 276.80
to USD 862.20 at the end of 2008, and breaching the USD 1000/troy ounce mark in the process.
In the same period, Moriarty (2009) noted that the value of the US Dollar Trade Weighted Index
(TWI) had depreciated by approximately 38%.
A depreciated US Dollar currency also contributed to the rise in gold price above the USD 1,000
mark, suggesting that gold is typically bought as an alternative to the dollar among safe-haven
assets favoured by investors seeking to preserve capital (Piovano, 2009), further suggesting a
correlation in the rise of gold prices when there is a drop in the value of the American currency.
These factors and numerous others that directly affect gold demand and supply are explored in
greater detail in the following chapters.
3.5 Price Economics and Descriptive Analysis
SAMPLE DATA
Having analysed the gold price evolution over the long term, this paper will now shift its
attention to testing the behaviour of gold price over recent years. For the purpose of
understanding gold price returns and its volatility, the most recent 5 years daily gold price data
from August 9, 2006 to August 8, 2011 is used for the sample period. Gold prices have been
extracted from the London Bullion Market using DataStream Thomson Reuters.
Comparative analysis is also undertaken for the results of the primary data against the two time
periods stated below, to gain a better understanding of the behaviour of gold price returns.
1. August 9, 2001 to August 8, 2006, and
2. January 3, 1968 to August 8, 2011.
Figure 3.2 charts the evolution of the gold price for our main sample data to show the dramatic
rise, where gold prices have almost tripled. There is a rapid and consistent rise in the prices of
gold over the sample period, but prices suffered a minor blip during the recession of 2007-08.

23
Figure 3.2: Evolution of Price of Gold Bullion(Daily; Aug ’06 – Aug ‘11) – USD/Troy Ounce
Source: London Bullion Market.
PRICE RETURN
To provide key descriptive analysis on the returns distribution of daily gold price data, the log of
returns are used. Using log in calculating returns reduces the effects of the outliers, or extreme
jumps within the price series. Daily return of the gold price is defined as:
˞ = ˬJ Ә
%
ә ≈ %
%
............... (2)
where˟ denotes the spot price of the commodity at time t.
Figure 3.3 charts the daily return of gold price over the 5 years period. We can identify large
spikes around the end of 2007 and early 2008, corresponding to the global recession and
turmoil that the world economy encountered around that period. Otherwise, returns have
remained largely stable. It can also be identified by the large downward spikes throughout the
60075090010501200135015001650
Aug 06 Aug 07 Aug 08 Aug 09 Aug 10 Aug 11
Timeline

24
sample period in contrast to the relatively few large upward spikes that although the rise has
been constant but rapid, the falls in price and thus returns have been greater and sudden.
Figure 3.3: Gold Price (log) Returns(Daily; Aug’06 – Aug ’11)
PRICE VOLATILITY
Figure 3.4 shows the gold price volatility on a rolling 22-day annualised rate3, where the
annualised volatility rate displays a fluctuating trend, ranging between 10% and the 20% mark.
However, during the recession, prices started to show more volatility, and reached a peak
annualised volatility of 54.77% in October 2008, corresponding to the sudden price rise and fall
during that month (see figure 3.2).The annualised volatility for gold over the five year period is
quite high at 21.45% (see table 3.1).
On the other hand, annualised volatility for gold is not quite high as some of the other
commodities such as oil, where standard deviation is 0.02248 and annualised volatility is
approximately 36%. Gamen (2005) mention that the volatilities of commodities range
significantly higher than that of equities due to the limited resources and the associated storage
3
See 12.1 Appendix A – Key Descriptive Analysis regarding annualised volatility formula (261 trading days).
-.1-.050.05.1
GoldPrice(log)Return
Timeline

25
costs. However, with the theory of storage not holding true for gold due to gold’s store in value
as an investment, the annualised volatility is much lower than other commodities.
Figure 3.4: Gold Price Rolling 22-Day Annualised Volatility (Aug ’06 - Aug ’11)
KEY DESCRIPTIVE ANALYSIS
Table 3.1 summarises the first four moments4 of the daily gold price return over the last five
years; and compares the results with two other time periods. The skewness for gold returns
displays negative properties over the two shorter periods of 5 years, but displays positive
skewness over the long run.
The kurtosis for the returns distribution is also above the normal5, indicating that the
distribution has fatter tails or ‘leptokurtosicity’. Deaton & Laroque (1992) and Myers (1994)
suggest in their respective papers that commodity return distributions suffer from excess
kurtosis, and that the distributions appear to be much fatter than the normal, and this holds
true for our sample data. Mills (2004) also investigated the statistical behaviour of daily gold
price data from 1971 to 2002 and concluded that daily returns are leptokurtic (p. 566).
4
See 12.1 Appendix A – Key Descriptive Analysis formulae of the first four moments of a distribution.
5
Under normal distribution, kurtosis equals 3.
10%20%30%40%50%60%
GoldAnnualisedVolatility
Timeline
Rolling 22-day Annualised Rate

26
Commodity Gold Bullion – Daily Returns
Period Aug ’06 – Aug ‘11 Aug ’01 – Aug ‘06 Jan ’68 – Aug ‘11
Underlying Spot Spot Spot
Source LBM LBM LBM
Mean 0.00072 0.00067 0.00034
Standard Deviation 0.01328 0.00992 0.01275
Skewness -0.27133 -0.26021 0.20540
Kurtosis 6.62934 6.52917 31.18532
Annualised Volatility 21.45% 16.03% 20.60%
Table 3.1: Data Analysis of Gold Price Returns
Comparatively, the mean for gold price returns is the furthest away from 0 for this sample
period (primary sample data), and it has also witnessed greater kurtosis in the returns,
suggesting the higher occurrence of extreme events. The most recent five years period also
recorded the highest annualised volatility, as gold price fluctuations coincided with the
downturn of the global economy which witnessed the major credit recession of 2007-08.
Over the long run, annualised volatility for gold is just over 20%; and the five years leading to
2006, annualised volatility was much lower at the 16% mark, suggesting more stable gold
returns over that period (see table 3.1).
3.6 Summary
The basic analysis of the evolution of the gold price brought to the fore several factors that are
key drivers of the price of gold. Extending this further, the fundamental analysis will focus on
the primary factors such as the supply and demand of gold, and other economic factors such as
currency movements, risk-free rate of return on T-bills, and the consumer price index
measuring inflation. It will explore the economic growth on the basis of stock index movements
and its correlation with the price of gold. The analysis will also seek to understand the influence
of other volatile commodities such as crude oil, and its effects on gold prices.

27
4. The Demand for Gold
4.1 Introduction to Gold Demand
Gold, for many centuries now, has held its status of beauty, power and a symbol of wealth. Its
rarity and value have always captivated humans, and it is currently the favoured instrument of
investment for investors and speculators alike. This paper has already explored the long history
and popularity of gold, and it is safe to say that its demand is relentless, even more so during
times of economic, financial and political crisis. Gold demand is also one of the most influential
drivers of its price due to the highly elastic demand nature (Kemmerer, 1944). It probably also
has the most elastic demand of all commodities on the market. Figure 4.1 charts out the 5-year
average demand for gold in three of the most influential sectors. These are 1) the demand for
ornamentation 2) the hoarding & investment demand and 3) the industrial and dental demand6.
Figure 4.1: Demand Flows: 5-Year Average (Q4, 2005 – Q3, 2010)
Source: GFMS Ltd., WGC (2011).
6
See 12.2 Appendix B – Global Gold Demand in Tonnes for a 3-year gold demand overview.

28
Demand for gold is widely dispersed around the world, with East Asia, the Indian sub-continent
and the Middle East accounted for approximately 70% of world demand in 2009. India, China
and Hong Kong, US, Turkey and Saudi Arabia represented over half of the world demand (WGC,
2011) (see figure 4.2).
Figure 4.2: Annual Demand for Gold (tonnes) 10 year average (1996-2005)
Source: GFMS Ltd. in Dempster, 2005, p. 1.
4.2 Demand for Ornamentation
For centuries now, gold has played an essential role in the jewellery industry due to its colour,
natural beauty, malleability and resistance to corrosion. Drost & Haubelt (1992) undertook
extensive research into the uses of gold for jewellery production prior to 1992 and concluded
that approximately 2,000 tonnes of gold is being used for ornamentation, which amounted to
approximately 75% of the total demand for gold. This amount was also confirmed by Green
(1993), and estimated the total demand of gold for jewellery production at 2,217 tonnes. As of
2011, the World Gold Council confirmed that jewellery consistently accounts for over two-
0100200300400500600700800
AnnualGoldTonnes*Demand
India United States China Turkey Saudi Arabia UAE
* Jewellery, coins and bars, medallions and imitation coins, industrial and decorartive uses
10-Year Average (1995-2005)

29
thirds of gold demand, and that in the 12 months leading up to December 2009, the rising
appetite for jewellery across the world makes it one of the largest sectors of consumer goods.
India, by virtue of symbolising gold firmly within their culture, religion and traditions, is the
largest market for gold jewellery in the world. Overall, India accounts for 746 tonnes of gold in
2010 (WGC, 2011). For Hindus, which represent approximately 80% of India’s 1.2 billion
population, it is a symbol of wealth, prosperity and bringer of good fortune. Gold also plays an
important role in marriages within the Hindu tradition, where brides are adorned with gold
jewellery from head to toe. And apart from gold being strongly associated with through culture
and traditions, it is seen as a means of financial security during tough economic conditions.
Gold is also one of the few ways where Indians can diversity their currency exposure of Rupees,
and hence, gold investments in jewellery are very popular (Dempster, 2005, p. 2). Surprisingly,
gold demand in India is based more on these cultural and religious references that are not
directly related to the economic trends and future forecasts.
Still, the recession of 2007 had a severe downturn impact on consumer spending, leading to the
decrease in sales volume within the jewellery sector (see figure 4.3).
Figure 4.3: Gold Demand (Volume) and Gold Price (USD/Troy Ounce)
Source: GFMS Ltd., World Gold Council (2011).
10040070010001300
GoldBullionPrice*-USD/TroyOunce
05001000150020002500
GlobalGoldJewelleryDemand(Tonnes)
2008 2009 2010
Year
Jewellery Price
* London PM Price Fix

30
Since then, jewellery demand in India and China has been recovering since the impact of the
recession, and Asia has started to see continuous growth and consumption, thus contributing
heavily to the increase in global demand in the previous year (2010). The recession also led to
the increase in prices of gold as investors sought safety to protect the value of their portfolios.
Batchelor & Gulley (1995) analysed the relationship between jewellery demand and the price of
gold to understand the effects of increased supply due to new technologies and cheaper mining
and production costs. The research concluded that there is significant price elasticity in gold
prices, and that the necessary price movement depends on the responsiveness of the demand
for gold jewellery to changes in the gold price (p. 41).
Overall, the demand for gold for jewellery production and consumption depends on a multitude
of factors, out of which, the price playing an important role. Other factors such as the
consumer’s desire, income and beliefs also play influential roles. Gold’s future prospect looks
bright despite the volatility in prices, and over the long run, gold prices will steadily rise during
stable economic conditions due to its importance and value.
With India7, China and other countries offering significant growth potential, the demand of gold
will also rise in the face of high gold prices.
4.3 Hoarding and Investment Demand
Hoarding demand i.e. accumulating gold in private possession is a common practice during
times of uncertainty and fear, and that hoarding gold is mainly prevalent in China and India due
to its symbol of wealth, and the opportunity to immediate respite. Kemmerer (1944) even
suggests that due to the large amounts of gold hoarding in India, she is known as the ‘sink’ of the
precious metals, draining the world economy’s markets of the valuable resources.
Clearly, the high demand for gold during uncertain times contributes to the high degree of
elasticity of demand, and thus is an important factor in determining gold prices. Another reason
why investments within gold will continue to rise is because of the positive price outlook. This is
because the demand for gold will continue to outstrip its supply.
7
For an in-depth study, refer to the WGC Gold Report on India: Heart of Gold - Revival (November, 2010).

31
Cosgrove (2010) suggests that due to the present economic uncertainties brought on by the
fluctuating US dollar, threat of inflation and growing global debt, investments within the gold
market makes logical sense. The article even goes on to suggest that it is the ultimate safe haven
asset, an opinion that is also shared by O'Byrne (2009). However, in a separate paper, O'Byrne
(2009) suggests that because of the major differences in the various motivations for buying gold
and ways to buy gold i.e. from trading and speculating to investing and saving, it is essential to
undertake due diligence into the asset type.
Unlike the jewellery demand for gold that saw a dip in 2009 (see figure 4.3 above), the
investment demand has seen no such downturn in demand. The WGC (2011) reported a year on
year rise of 7% from 2009 to 2010 for the investment demand of gold, rising from 1394.8 to
1487.4 tonnes8. For The Wall Street Journal, Nayak & Mukherji (2011) report the rise in
investment demand for gold in India, with traders and businesses reporting above-average
trading activities.
China is not to be left behind. With the price rise, most Chinese are pouring their hard-earned
money into the gold market, but are slightly more circumspect about an investment bubble
(McGregor, 2011). However, the nature of the commodity, i.e. gold is considered a good buy in
itself in light of the current global economic conditions. Both articles and countless others have
reported that with prices hitting record levels in trading, investors are rushing to seek a safe
haven after S&P’s actions to downgrade of the American economy’s debt rating. ‘These
mammoth trading ranges continue to reflect the lack of confidence and instability of the European
Union, United States, and growing concerns with China's high inflation...’ (Daly, 2011), and this
sums up the high demand for gold, affecting its price severely.
4.4 Industrial and Dental Demand
The industrial and dental demand for gold accounts for approximately 11% of the total gold
demand (see figure 4.1 above), and is thus the least contributor to the global demand of gold.
As described earlier, the industrial uses of gold are plenty in the modern age, and gold is now
being extensively used in electrical products and its components due to its high thermal and
electrical conductivity. Gold is used in the medical world for surgeries, the formulation of
8
See 12.2 Appendix B – Global Gold Demand in Tonnes for a 3-tear gold demand overview.

32
modern medicines and dentistry. It has been used in the space industry and technology for the
construction of components within the space shuttles and aircrafts.
Gold has also left its mark on the architectural world, because of its renowned thermal
properties. It has been used to coat the exterior of several iconic buildings such as the Royal
Bank of Canada building in Toronto, Canada and other buildings around the world to keep
heating and cooling costs low.
The industrial demand for gold is bound to be affected during price rises, as it is highly elastic in
nature. The limited supply and the ever growing demand is also a contributing factor to gold
prices. Hence, a price rise during tough economic conditions will bring about a downturn in
demand for industrial uses, and will thus affect the demand-supply relationship.

33
5. The Supply of Gold
5.1 Introduction to Gold Supply
Precious metals such as gold and its prices tend to react to the level of inventories, i.e. the
difference between demand and supply within the market. When analysing the history of gold
earlier, this paper briefly mentioned the gold rush in California and South Africa, leading to a
sudden increase in the supply of gold. However, that was only one of the factors that affected
the supply of gold back in the nineteenth century. With modern technologies available, and most
of the world gold already excavated, the origins of supply have changed.
The World Gold Council (2011) states that the three major sources of gold supply are 1) mine
production 2) recycled gold or old gold scrap and 3) the Central Banks9 (see figure 5.1).
Figure 5.1: Supply Flows: 5-Year Average (Q4, 2005 – Q3, 2010)
9
See 12.3 Appendix C – Global Gold Supply in Tonnes for a 3-year gold supply overview.

34
Figure 5.2 segregates the above-ground stock of gold into the major demand sectors for the year
ending 2009, providing a glimpse of the distribution of nearly 165,600 tonnes of gold supply.
Jewellery consumption accounts for over 51%, with the next largest stock held within the
official sector.
Figure 5.2: Above-Ground Stocks, End of 2009 (165,600 Tonnes)
5.2 Mine Production
Gold is extracted from its ores that are found beneath the earth’s surface across the globe. With
the recent rise in prices of gold, gold mining companies are looking to increase production, and
Foley (2007) reported for Bloomberg that with demand for gold rising in several key markets
such as India, China and the Middle-East, mining companies are willing to take the risk of higher
production costs to boost output. There is an opportunity to capitalise on the rise of gold prices
by increasing production, and thus increasing profits (Radetzki, 1989).
In 1934, profiteers triggered a seven-year mining frenzy after prices jumped from USD 20.67 to
USD 35/troy ounce (Green, 1968). In the current day and age, mining companies are now
hoping to reap rewards of this sudden upward price movement. However, Foley (2007) also
mentions the fears of a rapidly depleting supply, which was confirmed by Barrick Gold Corp.,

35
the world's largest gold producer. Extracting gold from deeper and older mines is difficult, and
that the global mine supply is going to fall at a much faster rate than expected.
Overall though, the WGC suggests that the global mine production is relatively stable. Over the
last few years, world gold production has averaged 2,497 tonnes approximately (WGC, 2011)
and the yearly gold production in tonnes is provided in table 5.110.
Year World Gold Production (Tonnes)
2001 2,604.00
2002 2,543.00
2003 2,593.00
2004 2,463.00
2005 2,518.00
2006 2,468.70
2007 2,444.00
2008 2,356.00
Table 5.1: World Gold Production (Tonnes)
Source: www.goldsheetlinks.com/goldhist.htm[Accessed: 8th August, 2011].
INELASTIC SUPPLY OF GOLD
The WGC suggests that the stability of gold supply is essential, because unlike the demand for
gold which is mostly elastic, the supply is relatively inelastic. There are long lead times to
produce gold, and it may take up to 10 years for new mines to come on stream.
A sustained growth in price of gold as seen in the last 5 to 7 years still doesn’t translate easily
into increased production. Hence, the supply will be unable to respond to changes in price
caused by high demand, and this fall in gold supply will contribute to high gold prices (WGC,
2011).
10
See 12.4 Appendix D for the Global Gold Production (Tonnes) for 20 Years.

36
5.3 Recycled Gold – Old Gold Scrap
Gold has several attractive properties, one of which is that it is virtually indestructible. Its shape
and form can be altered with relative ease, and it is an economically viable product because it
can be re-used countless times. Recycled gold or old gold scrap is a major supply source because
there is a large market for hoarding gold.
During times of a price rise, consumers will seek to book their profits by selling off this hoarded
gold. Abraham (2008) indicated that the sales of gold scrap in India have increased as record
prices consumers to recycle more old jewellery, curbing demand for new supplies of bullion.“In
Mumbai alone, we have seen purchases of old jewellery of 30-40kg a day,” Bombay Bullion
president Suresh Hundia, said. “There have been zero imports in the past 15 days,” he added
(Abraham, 2008). An article by BullionVault in 2009 suggested that although India is a major
buyer of gold before and during the autumn festive and wedding season, consumers are cashing
in their gold investments due to the rise in prices, and that the quantity of recycled gold rose by
12.5% in Q3 for 2009, compared to Q3 of 2008.
With fears regarding the American economy and the Euro-zone crisis, Economic Times (2011)
reported heavy unwinding of gold stocks by speculators, triggering a price retreat from its
overnight new record high of USD 1,813.79/troy ounce. Strategists at Financial Times suggested
that the market was ripe for a short-term sell-off (Farchy, 2011).
Clearly, a sudden rise in price has led to the increase of old gold scrap, thus increasing the
supply dramatically. This has effectively caused the prices to drop and curbed gold prices from
hitting through the roof, if they haven’t done so already! Through the forces of demand and
supply, the gold price rise was checked though massive sell-offs. Between 2005 and 2009,
recycled gold contributed an average 32% to annual supply flows (WGC, 2011). Table 5.2
provides a summary of the supply of the previous 3 years.
Year Recycled Gold (Tonnes) Total Supply (Tonnes)
2008 1,316.00 3,606.00
2009 1,695.00 4,081.00
2010 1,645.00 4,155.00
Table 5.2: Gold Supply – Recycled and Total (Tonnes)
Source: GFMS Ltd., WGC (2011).

37
5.4 The Central Banks
The monetary demand of gold was substantially high during the gold standard days as principal
economies, alongside financial institutions aimed to maintain significant gold reserves. But after
the US Treasury, in conjunction with the International Monetary Fund (IMF) demonetized gold
entirely in 1971, the world economy moved onto its present financial system but left the gold in
the vaults of the central banks, leading to sales by both the IMF and the US Treasury in the late
1970s (Green, 1993). Hence, the demonetisation drive of 1971 has effectively turned the Central
Banks and official gold holding institutions into the current suppliers of gold (Green, 1993).
Since 1971, the reserves of various countries and the IMF have changes drastically. Taking
gold’s present stock (as of August, 2011) of official gold holdings, the US is the current leader
with 8,133.5 tonnes, and China placed sixth with 1,054.1 tonnes. In 2009, the IMF initiated the
gold sales program to put IMF’s financing on a sound long-term footing (IMF, 2011), and
decided to sell 403.3 metric tonnes. India purchased 200 tonnes in 2009, under speculation that
the central banks is looking to protect and diversify their holdings against a weakening US
Dollar (Abraham & Kyoungwha, 2009). This totalled India’s official gold holdings to 557.7
tonnes, and placing her eleventh on the list11, taking India past the European Central Bank
(ECB). A brief summary of gold holdings for several countries is provided in table 5.3 below.
World Official Gold Holdings Tonnes
World (Total) 30,700.10
All Countries Only 27,372.60
United States of America 8133.50
Germany 3401.00
IMF 2814.00
China 1054.11
India 555.70
European Central Bank (ECB) 502.10
United Kingdom 310.30
Table 5.3: Summary of World Official Gold Holdings, August 2011
Source: IMF International Financial Statistics on World Gold Council, 2011.
11
The complete list can be found at: http://www.gold.org/government_affairs/gold_reserves/

38
6. Factors Influencing Gold Price
6.1 Literature Review
OVERVIEW
There have been numerous studies undertaken in the past that have attempted to understand
gold price movements. Through research, most of the different studies can be categorised into
three main groups.
The first group of studies by Koutsoyiannis (1983), Diba & Grossman (1984), Baker & Van
Tassel (1985) and Pindyck (1993) focuses on the rationality of gold prices, i.e. speculation of
gold prices in the short-run based on certain determinants to establish a relationship between
prices and the determinants.
The second group of studies focuses on the implications consumer price index (CPI) and
inflation rates has on gold prices, and attempts to examine whether gold is a suitable hedge
against inflation. Studies by Sherman (1983), Moore (1990), Madhavi & Zhou (1997), Chappell
& Dowd (1997), Ghosh et al. (2004) and Gorton & Rouwenhorst (2006) look extensively into
this relationship.
The third group of studies by Fortune (1987), Kaufmann & Winters (1989), Dooley, Isard &
Taylor (1995), Sjaastad & Scacciallani (1996) and Lawrence (2003) focuses on gold price
movements in relation to movements in certain macro-economic variables such as the rate of
inflation, the exchange rates, the interest rates and the performance of the stock indexes, etc.
As this paper looks to statistically model the nature of gold price in relation to a number of
macro-economic factors, this research paper falls into the third group. A brief summary of some
of the past research has been included.

39
RATIONALITY OF GOLD PRICES
Research by Koutsoyiannis (1983) focused on understanding whether gold can be used as a
speculative asset in the immediate short run, and thus developed a dynamic model to
understand the rationality of gold prices. Testing a sample of 316 daily observations from
January 1980 to March 1981, the research concluded that gold price has a significant
relationship with several factors including dollar valuation, US inflation and interest rates.
These factors affected gold price and had accounted for 95% of the total gold price variation.
However, due to short-term market inefficiency, the daily gold prices did not incorporate most
of the information available on the market immediately.
Pindyck (1993) uses the daily future prices of four commodities, i.e. copper, lumber, heating oil
and gold from 1974 to 1989 to test the present value model, which is a reduced form of a
dynamic demand and supply model. The present value model did a poor job in modelling prices
for most commodities except oil. For gold price modelling, the performance of the model was
most inaccurate and this was attributed to the different (low) levels of convenience yield among
precious metals.
GOLD AS A HEDGE AGAINST INFLATION
Sherman (1983) tested the relationship between gold prices and inflation using regression
analysis from 1970 to 1980 on an annual holding period and found significant correlation
between the two factors.
Moore (1990) analysed gold price in relation to inflation from 1970 through to 1988 on a
monthly basis and concluded that gold prices are predicted by a leading indicator of inflation. If
investors followed the buy-and-sell signals rule which was linked with the inflation index and
the gold prices, they stood a chance to earn 18 to 20% annually on average over the test period.
The results also concluded that holding gold over this period provided better returns than
stocks and bonds.
Ghosh et al. (2004) undertook co-integration regression analysis for monthly gold prices from
1976 to 1999, and confirmed that investments in gold can be strongly regarded as a long-run
inflation hedge and that the price movements in gold are majorly dominated by short-run
influences. Using the log of these two factors also confirmed the results, and suggest that the
results are in line with the theory of price of gold, where the error-correction mechanism was
statistically significant, implying that gold prices and US inflation moves together.

40
However, there are some research papers that cannot conclusively identify a relationship.
Madhavi & Zhou (1997), Lawrence (2003) and Tully & Lucey (2007) find weak evidence that
gold prices are contributory factors to inflation predictions, and suggest that there is
insignificant correlation.
Using quarterly price data for gold from 1970 to 1994, Madhavi & Zhou (1997) tried to improve
the inflation rate forecast through specifying error-correction models, but found no evidence for
a co-integrating relationship between gold prices and inflation. Thus, while there is enough
evidence suggesting a strong relationship between inflation and gold prices, there are empirical
studies which establish a lees clear relationship.
GOLD PRICE AND MACRO-ECONOMIC FACTORS
Dooley, Isard & Taylor (1995) conducted numerous empirical tests to examine whether
movements in exchange rates had any statistical significance on gold price movements in the
short and long run. Using co-integration and multivariate modelling techniques with date
ranging from 1976 to 1990, their findings showed that gold prices have explanatory power with
respect to exchange rate movements, over and above the effects of movements in monetary
fundamentals and other variables that enter standard exchange rate models. The paper
concluded that gold is viewed as ‘an asset without a country’ and thus is an attractive
alternative investment option.
Sjaastad and Scacciallani (1996) undertook a similar study to Dooley, Isard and Taylor (1995),
where they investigated the relationship between exchange rate movements and gold price
between the 1982-1990 period, using daily data. Their findings concluded that the European
currencies had a greater effect on the price of gold than the US Dollar. The study also
emphasised that floating exchange rates significantly contributed to the volatility of gold prices
during the test period.
Kaufmann & Winters (1989) used a simple regression model to examine the relationship
between various macro-economic variables and the price of gold. The explanatory variables in
the regression model included US inflation rate, the US exchange rates and the production of
gold across the world against the dependant factor, i.e. gold price. Testing for a period of 14
years between 1974 and 1988 using monthly data, the results showed strong correlation
between the explanatory and dependent variables.

41
6.2 The US Dollar and Price of Gold
‘THE TRIFFIN DILEMMA’
Robert Triffin (1911-1993), a Belgian economist was a stout believer that the Bretton Woods
system of fixed exchange rate was flawed and hence proposed a diagnosis that soon became
known as ‘The ‘Triffin Dilemma’ (Altman, 1961; in Triffin, 1978, p. 2). Triffin (1961) challenged
the amount of reserve adequacy supplied by the US government and federal banks, and
suggested that if the United States’ national currency continued to serve as the international
reserve currency, there could be greater conflicts of interest and tension between the short and
long term objectives of the American economy and monetary policies.
The resulting trade deficit that the American economy would incur will be substantial if the
United States continues to pursue serving as the international reserve currency, and is willing to
supply the world with an extra influx of its own national currency to fulfil this world demand.
Triffin (1961) concluded that in the absence of any specific planning and policies, the growing
inadequacy of world reserves would be most likely to lead, within a relatively short span of years,
to a new cycle of international deflation, and restrictions, as it did after 1929 (p. 70).
Eventually, the Congress and the Fund were persuaded, and the theory by Triffin proved
prescient – the Bretton Woods system was abolished in 1971.
However, Central Banks around the world have continued to hold large reserves of gold despite
the fall of the Bretton Woods system that linked the currency to the value of gold. This is
because gold reserves are required in order to hold foreign exchange reserves to deal in global
trade transactions, and the preferred reserve currency for foreign countries is the US Dollar.
Triffin (1978) revisits the aftermath of the adoption of the floating exchange rates policy, but
concludes that due to the United States’ penchant for high inflation and its resulting
inconvenience, inflation has not been restrained through this policy. By maintaining its position
as the reserve currency, the US Dollar was increasingly overvalued during the Post Bretton
Woods period and this affected its competitiveness in world trade, leading to recessionary
tendencies and unemployment in important sectors of US industry (Triffin, 1978, p. 9).
Devaluations of the US Dollar followed immediately to correct the 1971 over-valuation, inflation
rose rapidly, and gold prices hit record levels during the 1970s. This price rise is documented
earlier in this paper (see figure 3.1 above).

42
CURRENCY WAR: THE US DOLLAR - CHINESE YUAN EXCHANGE RATE
The recession of 2007-08 prompted Dr. Zhou Xiaochuan, the governor of the People’s Bank of
China to suggest that the world needs a new global reserve currency, and explicitly highlighted
the ‘Triffin Dilemma’ as the root cause of the economic turmoil. In his speech, he proposed a
gradual move away from the dollar and towards the use of a global reserve currency through
IMF as a possible solution (Xiaochuan, 2009). He also proposed that the goal would be to create
a reserve currency that is disconnected from individual nations and is able to remain stable in the
long run, thus removing the inherent deficiencies caused by using credit-based national currencies
(Xiaochuan, 2009, p. 2).
Based on this speech, Anderlini (2009) suggests that there are clear indications to China being
the largest holder of US dollar financial assets. This is putting the US Federal Reserve at risk of
inflation by printing more money. The Economist (Sept 2010) points out that China’s trade
surplus had swelled to more than USD 100 billion in the third quarter of 2010 and America’s
trade deficit had increased due to China’s persistent policy of undervaluing its currency. Both
economies would like to reduce this.
The heart of this issue lies with China tightly pegging its currency against the US Dollar since
early 200812, and there have been loud calls on whether China is a currency manipulator. The
issue reached its peak in 2010, when tensions mounted in the Sino-American relationship
regarding the undervaluation of the Chinese currency. This situation had to be temporarily
defused by putting off the release of a semi-annual report on China’s exchange rate by Tim
Geithner, America’s treasury secretary (The Economist, Apr 2010). The article argued that that
a stronger Yuan will assist China in controlling its inflation and this will allow her to raise its
interest rates. Another article by Talley & Crittenden (2010) suggested that the United States is
frustrated with this situation and that US lawmakers could soon replace feisty rhetoric with
action on China... and may vote in the coming weeks on legislation penalizing Chinese imports for
Beijing’s artificially-low currency.
China’s currency appreciated soon after, but Geithner expressed concerns regarding the pace
and extent, suggesting that it was very limited. But Chinese officials dismissed these concerns,
and analysis by The Economist and numerous other financial presses suggest that China is
maintaining its position that America should better manage its currency and debt, rather than
put pressure on the Chinese government to appreciate its currency (Chan, 2010; The Economist,
2010).To explain the policy adopted by China on its currency valuation, Dr. Xiaochuan used a
12
See 12.5 Appendix E for US Dollar to Chinese Yuan exchange rate; with gold price evolution from August
2006 to August 2011.

43
metaphor. China have adopted the Chinese medicine approach – through trial and error, and
working gradually on the basis of results. On the other hand, Americans prefers the western
medicine approach – clinically proven through tests and research, and aggressive application
and treatment (The Economist, Dec 2010).
The overall imbalances in global reserves and currency wars have driven the price of gold to
record levels. McGregor (2011) explores the Chinese gold market which has also seen a recent
surge in demand, and mentions that governments all over the world are debasing their
currency. With the United States continuing to rebase its currency, investors and consumers will
take protection by investing in real assets such as gold during times of uncertainty.
The issue, it seems is not the undervalued Yuan, but the mismanaged reserve currency i.e. the
US Dollar. With loud calls of a new global reserve currency through the IMF, is gold the only safe
real asset available on the market currently? As this question is beyond the context of the
research objectives of this paper, it shall not be evaluated. However, further research can be
undertaken to explore the options or solutions for a new world reserve currency.
US DOLLAR CURRENCY HEDGE
Over years now, investors and speculators have suggested that gold as an investment is strong
protection against a currency’s depreciation. Blose (1996) sees investing in gold as hedging
against currency exchange risk and other factors, and also regards this investment as
particularly efficient. Research conducted by Capie et al. (2004) for the World Gold Council
examined the dollar-gold relationship from 1971 to 2002, and concluded that there is enough
evidence to show gold to be a remarkably robust hedge against dollar fluctuations (p.
27).Analysts established that throughout this period (1971-2002) of considerable economic
turbulence, gold offered investors consistently strong protection against instability and
exchange rate fluctuations (WGC, 2011).
Since 2005, prices of gold have risen enormously, from USD 450/troy ounce to USD 1750/troy
ounce in anticipation of the value of dollar depreciating. Such a devaluation of the dollar was
seen in 1973 (discussed earlier) when the Bretton Woods system was abolished and high wage-
based inflation was witnessed. Today’s financial concerns remain largely with the world reserve
currency i.e. the US Dollar being very fragile. As the US dollar depreciates (see figure 6.1),
investors are aiming to protect the value of their US Dollar investments through purchasing
gold. Effectively, gold is acting as a hedge against the US Dollar during this tough economic
climate.

44
Figure 6.1 also shows how the rate was held constant for a period of almost two years by the
Chinese officials. This was done in order to undervalue their currency against the US Dollar, but
Chinese regulators reacted soon after in the face of stiff pressure from the US government.
Figure 6.1: Chinese Yuan to US Dollar Exchange Rate; with Gold Price (Daily; Aug ‘06 – Aug ’11)
Source: GTIS - FTID/TR & London Bullion Market.
GOLD PRICE RELATIONSHIP – INVERSE
Moriarty (2009) predicts an inverse relationship between gold prices and currency valuations.
With gold acting as currency hedge to the US Dollar, there is strong evidence to suggest that an
inverse relationship exists between the value of the US Dollar and gold price. Milhouse (1997)
states that a small percentage shift and depreciation of the financial assets such as the US Dollar
would cause a large percentage increase in the gold price. Capie et al. (2004) highlight the
negative correlation that has consistently existed over time and across various exchange rates
between gold price and the US Dollar. Hence, this relationship will be tested in this paper to
establish our findings on whether gold prices are affected on the movements of the US Dollar
currency against the Chinese Yuan.
6.496.777.057.337.627.90
ChineseRenminbitoUSDollar
6008001000120014001600
Timeline
Gold Price Exchange Rate

45
6.3 Inflation Effects
INFLATION HISTORY
Inflation within the US economy was rampant before the floating rates exchange systems was
brought into force by President Nixon in 1971. It had become relatively easy to sell foreign
goods within the US economy and increasingly difficult to sell US products abroad due to the
price rise of US goods. Simply put, imports were exceeding exports, and foreign currency was
being drained out of the US economy during this imbalance of trade. And with the lack of
enough foreign reserves to carry out US operations in foreign countries such as the war in
Vietnam, Sweezy & Magdoff (1971) suggest that there has been a drastic weakening of the US
balance-of-payments position: on an international scale the United States is now living far beyond
its means (p. 173).Figure 6.2 plots the monthly US consumer price index with the gold price over
the long run13.
Figure 6.2: US Consumer Price Index; with Gold Price (Monthly; 1968-2011)
Source: U.S. Bureau of Labour Statistics & London Bullion Market.
13
See 12.6 Appendix F for monthly US Annual Inflation Rate; with Gold Price from 1968 to 2011.
04080120160200240
USConsumerPriceIndex
0300600900120015001800
GoldBullionPrice(Nominal)-USD/TroyOunce
1968 1972 1976 1981 1985 1989 1994 1998 2002 2007 2011
Timeline
Gold Price US CPI

46
However, the adoption of floating exchange rates post the Bretton Woods system has not been
able to restrain the high levels of inflation persistent within the American economy, and it
instead continued to rise rapidly. Over the period of eight years from 1970-1977, America’s
indebtedness to its treasury quadrupled, and its national banks were heavily liable to foreigners
(Triffin, 1978, p. 8). The high level of inflation led to the devaluation of the US Dollar in 1973,
but inflation threatened to spiral out of control. Gold prices rose and peaked to record levels
during this period and this was documented earlier in this paper (see figure 3.1 above).
Today though, gold prices are listed on nominal and not real terms, and are not adjusted for
inflation. Using real prices allow us to compare prices in varying time periods, and real prices
are calculated as:
˞˥Iˬ ˜J˩I˥ = Ә ә × ˚J˭˩JIˬ ˜J˩I˥ ............... (3)
Hence, the price rise of 1980, where it touched around USD 835/troy ounce would translate to
more than USD 2,400/troy ounce in today’s money if accounted for accumulated inflation
(Farchy, 2011). The recent prise rise of August 2011, when gold reached an all time nominal
high of around USD 1,735/troy ounce fails to surpass the 1980 prise rise. Figure 6.3 charts out
the monthly nominal and real price of gold from 1968 to 2011.
Figure 6.3: Nominal vs. Real Gold Price (Monthly; 1968-2011) – USD Troy Ounce
030060090012001500
GoldPrice(NominalandReal)-USD/TroyOunce
1968 1972 1976 1981 1985 1989 1994 1998 2002 2007 2011
Timeline
Nominal Gold Price Real Gold Price

47
QUANTITATIVE EASING
An article by Farchy & Terazono (2011) draws comparison of the current bull run of gold to the
1970’s bull run, and the similarities in the bullish factors that drove gold prices. The level of
anxiety prevalent within the market, the lack of confidence amongst investors, the growing fears
of sovereign debt defaults by the US and several Euro nations, alongside expectations of further
monetary easing policies have allowed gold prices to shine. Triffin (1978) reported the
distasteful measures of flooding the world market with reserve currency during the 1970s. The
US Federal reserve has been, over the past couple of decades, rapidly increasing the supply of
money and in the process issuing more debt. McMorris (2011) suggests that this subsequent
debt accumulation for a period of 30 years culminated with the debt bubble of the early 2000s
and the global debt meltdown of 2008.The Federal Reserve has already resorted to quantitative
easing twice in the last 3 years to boost the flagging economy suffering from this crisis14.
And currently in 2011, to tackle high inflation and recessionary conditions, the US has again
adopted a similar approach when President Obama agreed to sign the US debt-ceiling bill on
August 2, 2011. Gold prices rose very rapidly following this news to hit record levels. It is simple
economics that quantitative easing, i.e. the policy to increase the supply of money through
issuing and printing more currency will generate greater purchasing power among consumers.
This leads to the US dollar’s value to depreciate, and contributes to high inflation rates, and
forces the central banks to maintain low interest rates. The rate of money being issued i.e.
quantitative easing is greater than the rate of supply of gold within the market. Thus, the
consequent effect – gold demand outstrips supply and prices rise enormously.
INFLATION HEDGE
Blose (1996) sees investing in gold as hedging against inflation, political risk, and currency
exchange risk, and also regards this investment as particularly efficient. Over the years, the
general price tendencies has prompted numerous economists and analysts to note that a rise in
inflation has caused the prices of gold to increase, and thus have concluded that gold has
strengthened due to higher inflation (Cui, 2009; Lehman, 2009). Even the Federal Reserve has
indicated that gold prices and returns can be used as a measure of future inflation (Blose, 2010, p
36).This relationship has been tested under different parameters by numerous authors, taking
into account different time periods, varying holding times, and short and long term time spans.
When investigating the relationship between gold prices and inflation, Jaffe (1989), Moore
14
See 12.7 Appendix G for US monetary base from 1968 to 2011.

48
(1990), Haubrich (1998), and McCrown & Zimmerman (2006) conclude that there exists a
significant relationship. Overall, the WGC (2011) supports gold’s reputation as a safe haven
against the fluctuating nature of inflation over the long term. During sustained periods of high
inflation, gold can be used as a hedge against inflation with possibilities of impressive returns.
Figure 6.4: US Annual Inflation Rate; with Gold Price (Monthly: Aug ’06 – Aug ’11)
Source: US Bureau of Labour & London Bullion Market.
GOLD PRICE RELATIONSHIP – POSITIVE
For a long time now, inflation is considered to be the driving force for the price of gold. The
relationship between gold price and inflation exists during times of high inflation within the
economy. Under such circumstances, investors aim to protect the value of their investments by
investing in gold, thus raising gold prices within the market as gold demand outstrips supply.
Kaufmann and Winters (1989) mention that as the dollar yardstick for the price of a commodity
goes down, it takes more dollars to value the commodity. Because the main purpose of holding gold
is to store value, the price of gold should be expected to go up with inflation (p. 311). Hence, there
is positive relationship between gold price and inflation, suggesting that gold prices rise if
inflation rises or is unusually high. This relationship will be tested in this paper.
-20246
AnnualInflationRate-%
6008001000120014001600
Timeline
Gold Price Inflation Rate

49
6.4 Interest Rate Effects
EFFECTS OF INTEREST RATES
Interest rates play an important role within the economy, as it provides investors with an
alternative form of investment in an interest bearing risk-free assets or bond. Interest rates are
also the measure of borrowing currency15.
Shanmuganathan (2006) points out that every time the US Federal Bank announces a decision
on the US interest rates, gold prices also react, and highlights the negative correlation between
interest rates and gold prices. The theory is quite straightforward. When interest rates decline,
the lower return on the US Dollar loses the interest of foreign investors, and the demand for
Dollars decline. This lower demand depreciates the US Dollar exchange rate, and thus gold
becomes a more attractive investment opportunity. Hence the price of gold rises.
Wallace (2009) believes that the combination of unprecedented global fiscal stimulus,
quantitative easing, and increased money supply has the potential to result in broad currency
devaluation, negative real interest rates and possibility of high rates of inflation. It is natural
that gold prices react to a multitude of other economic factors simultaneously acting within the
economy. Hence, it is usually difficult to pinpoint a particular gold price driving factor. The
previous section on inflation, and the effects of quantitative easing policies highlighted the
downside of short-term cash injections into the financial system by the Federal Reserve through
buying up the debt of the US economy.
The BBC (2011) reported on August 23, 2011 that gold prices and stock markets have risen on
news that further stimulus measures by the US Federal Reserve is expected very soon to lift the
economy, and that the US central bank plans to keep the short-term interest rate close to zero
until 2013. There are even suggestions that further quantitative easing will depreciate the dollar
even further, forcing the US economy to continue with low interest rates, which will push gold
prices even higher (Piovano, 2009, Wallace, 2009; BBC, 2011). There is greater appeal to invest
in gold when interest rates are low.
Figure 6.5plots the gold price over the last five years in relation to the 6 month T-bill rate
prevalent in the US. During the pre-recession period in 2006 and early 2007, when the 6m T-bill
real rates were comparatively higher (hovering around the 5% mark), gold prices were stable.
15
See 12.8 Appendix H for daily 6 Month T-Bill Middle Rate; with Gold Price from 1968 to 2011.

50
Figure 6.5: 6M T-Bill Rate; with Gold Price (Daily; Aug ‘06 – Aug ’11)
Source: U.S. Department of the Treasury & London Bullion Market.
But post the recession of 2007-08, short term fiscal policy and quantitative easing has led to the
depreciation of the US Dollar and fall in interest rates sharply. Gold prices have also responded,
and have risen rapidly. Hence we can identify a strong inverse relationship from figure 6.5.
OPPORTUNITY COST OF HOLDING GOLD
Low interest rates in the US and global markets were also a contributing factor to high gold
prices (Radetzki, 1989; Laird, 2006).Julian Jessop, an economist at Capital Economics noted that
near-zero interest rates reduces the opportunity cost of holding gold (Piovano, 2009), since
investors would not be earning substantial amounts of interest on cash holdings, savings or
other interest-earning forms of investment. This view is also shared by Abken (1979), Radetzki
(1989), Laird (2006) and many others.
Gold is money after all, but gold investments do not pay out dividends or interests unlike
equities or treasury bonds and this marginal interest cost reflects the opportunity cost of owning
0.200.201.101.102.002.903.804.70
UST-Bill6MonthMiddleRate(%)
6008001000120014001600
Timeline
Gold Price 6m T-Bill Interest Rate

51
additional stocks of noninterest-bearing gold rather than alternative interest-bearing assets
(Abken, 1979, p. 3).This works on the principle that if interest rates are high, investors can earn
substantial return on an interest bearing asset or investment. But, if an investor chooses to buy
gold instead, this real interest is forgone, and thus opportunity cost incurred. However, if
interest rates are low, this opportunity cost is almost negligible. Hence, the low interest rates
present within the US economy is driving the prices of gold considerably high.
GOLD PRICE RELATIONSHIP - INVERSE
Abken (1979) notes that a rise in short-term real interest rates increases the opportunity cost of
holding gold investments, and thus leads to the decline in gold demand. This causes gold prices
to fall. Hence when interest rates are on the rise, gold prices tend to decline.
On the other hand, Laird (2006) suggests that investment in gold tends to rise when real
interest rates becomes negative (falling rates), which leads to the inflation rate exceeding the
interest rate, and the US Dollar depreciating in value. As gold does not earn or lose any interest,
gold investors are immune to these negative real interest rates. This greater demand causes
prices of gold to rise. Hence, we observe an inverse relationship between real interest rates and
gold prices, and this is graphically confirmed by looking at figure 6.5 above. This relationship
will be tested in this paper.
6.5 The US Stock Index and Financial Markets
STOCK MARKET OVERVIEW
The price movement of gold has been strongly linked with the performances of the stock
market. In their research, McDonald & Solnik (1977) find negative correlation of 0.4 for the
returns of S&P 500 stocks and gold during the period of 1948 and 1975. Hillier et al. (2006)
analysed the period from 1976 to 2004, and conclude that all precious metals including gold
provide a suitable option for portfolio diversification, and that they have hedging capabilities
during periods of abnormal stock market volatility. In 1987, the sudden nature of the ‘Black
Monday’ stock market crash led to the rise in gold prices. Investors sought after immediate
safety, and invested in the bullion. But after the world markets stabilised, gold prices started to

52
decline as the equity markets started to gradually rise. Since then, there has been a steady
growth in the stock market, and gold prices have remained low.
Then, before the turn of the new millennium, stock markets were rallying on the technological
advances seen in the online industry which was often referred to as the dot com bubble16. Gold
prices remained low as investors preferred the risk and return properties of equities as it
guaranteed higher returns during the bullish period. However, stock markets collapsed in 2001
after the Enron debacle and the bursting of the dot com bubble, leading to volatile stock market
conditions. Gold prices started to see a steady rise, but nothing substantial in compared to the
fluctuation within the equity markets. Then, post the September 2011 terrorist attack on
American soil, and the decision to go to war in Iraq and Afghanistan, gold prices started to rise
dramatically as the US Dollar depreciated. Stock markets collapsed in 2001 and 2002, but
recovered over the five years leading to the recession of 2007-08 during which the progress of
the stock markets was dramatically checked.
RECENT PRICE MOVEMENTS
Over the last 3 years, the US stock markets have declined sharply on deep recession fears. As
panic and chaos set in amongst investors to sell their shares and cut their losses, share prices
plunged and this translated into substantial decline of the S&P 500 index. The high levels of debt
and the lack of credit availability was highlighted as the reasons for the economic downturn.
Monetary policy to curb the spiralling debt involved issuing more currency into the economy,
thus raising consumer prices. The value of the US Dollar fell and interest rates were cut sharply,
and gold prices rose rapidly in response to volatility on the stock markets. Gold prices continued
to climb and hit a record-high back in 2008 of USD 1000/troy ounce, and suggested that it is yet
to hit its peak due to concerns on the shakiness of the US economy (Mullins, 2008).
The predictions turned out to be true. Gold prices continued its upward rise, but so did the S&P
500 index. However, the constant threat of default from numerous European Union member
countries checked the growth of the global markets. Then in August 2011, the US markets
declined sharply on fears of financial crisis in the Euro-Zone and the credit rating downgrade of
the United States from AAA to AA+ by Standard & Poor’s. The S&P 500 index witnessed its
highest single-day fall in over a year on August 2, 2011 (see figure 6.6), and the Economist
magazine headlined its cover - ‘Time for a Double Dip? The Growing Fear of another American
Recession’ (The Economist, 2011), suggesting fears of longer term stagnation.
16
See 12.9 Appendix I for daily S&P 500 Index; with Gold Price from 1968 to 2011.

53
Figure 6.6: S&P 500 Index; with Gold Price (Daily: 1968-2011)
Source: Standard & Poor’s & London Bullion Market.
Following the news of the credit-rating downgrade, gold prices skyrocketed to record levels as
investors sought safety. Investors are piling out of many asset classes and into gold which is seen
as a less risky investment in times of turmoil (The Wall Street Journal, 2011), and as a result,
banks such as Goldman Sachs reacted to the news by raising their gold price forecasts. This,
once again confirms the fact that gold prices and stock market performances are inversely
correlated.
GOLD PRICE TO S&P 500 INDEX RATIO
The gold price to S&P 500 index ratio, which is calculated by dividing the price of an ounce of
gold by the S&P 500 index, is a good indicator of the behaviour of the two factors against each
other over the long run. Gold/S&P 500 ratio explains how many S&P 500 index points are
required in order to buy one ounce of gold. Conversely, the S&P 500/gold ratio explains how
many ounces of gold are required to buy one S&P index point. This paper focuses on the
gold/S&P 500 ratio. Over the last two years, the gold/S&P 500 ratio has been hovering in the
7107108701030119013501510
S&P500IndexPoints
6008001000120014001600
Timeline
Gold Price S&P 500 Index

54
range of 1 to 1.2 (see figure 6.7), i.e. it requires between 1 and 1.2 S&P 500 index points to buy
one ounce of gold, suggesting that the stock markets are not performing as bullishly as gold
since a greater number of index points are required to purchase one ounce of gold.
Figure 6.7: Gold Price (Ounce) to S&P 500 Index Ratio (Daily: Aug ’06-Aug ’11)
And recently, stock markets have further receded on fears of a double-dip of the world economy
after the announcement by the US to increase its debt ceiling. This raised fresh fears among
equity investors and equity investors sought refuge in the bullion, thus raising the prices of gold.
The ratio that was on the rise over the past four weeks, finally hit a 23-year high by touching 1.4
when S&P index fell and gold prices rose simultaneously. Tang (2011) reports that further
economic shocks should force the ratio to rise even further, as both the US Dollar and the Euro
are in trouble.
Post the recession of 1987, the ratio has averaged below one until the aftermath of the global
recession of 2007-08, suggesting that stock markets rallied and outperformed gold17. However,
the ratio took a dramatic upward turn since investors lost faith in world equity markets, and
favoured gold at the expense of other riskier investment options.
17
See 12.7 Appendix G – Gold Price to S&P 500 Index Ratio in the Long run.
0.40.60.81.01.21.4
GoldPrice(Ounce)/S&P500IndexRATIO
Timeline

55
6.6 Oil Prices and Effects on Gold Price
POST BRETTON WOODS POLICY
The post-Bretton woods system is often explained in conjunction with fixed and floating
exchange rate policies in numerous papers, including this one. It explores the effects on prices of
gold due to the persistence of high inflation. However, oil prices were also severely affected post
the collapse of the Bretton Woods policy.
Exploring the history of US Dollar oil prices and seeking to establish a connection between the
breakdown of the Bretton Woods Agreement and the sudden increase in oil prices during the
early half of 1970s, Hammes & Wills (2003) conclude that gold-buying and oil-selling countries,
with price-setting power, would respond to changes in the dollar price of gold in a predictable and
rational fashion. In times of rapidly increasing (decreasing) dollar prices of gold, we would expect
rapidly increasing (decreasing) dollar prices of oil (p. 1). The paper clearly suggests a very strong
connection in this relationship.
MACRO-EFFECTS OF OIL PRICES
In the commodity world, oil is one of the most important resources and also one of the most
researched due to its significant impact on world economy. Crude oil is traded using the world
reserve currency i.e. the US Dollar. Oil is also strongly linked to inflation, and usually, oil price
increases is a strong signal that inflation is on the rise as oil is an essential input factor in the
production of primary agricultural commodities such as wheat, corn and sugar. As a result, an
increase in the price of oil will increase the prices of primary commodities through higher
production costs, leading to higher inflation.
Oil is also a rapidly depleting natural resource that produces energy. A rise in oil prices will
cause its demand to fall, and this has two major effects. One, it leads to higher inflation as oil in
its various forms is used to production of other essential commodities, and two, the supply of
the dominating currency used in crude oil transactions i.e. the US Dollar increases as a result of
low trade volumes. This increased supply of currency and high inflation causes the US Dollar
rate to depreciate, and because gold is used as an inflation hedge, the demand for gold rises as
investors rush to invest in gold to protect the value of their investments.

MODI, S. A. (2011) Commodity Price Characteristics and Economics of Gold Price Movements. University of Nottingham.

MODI, S. A. (2011) Commodity Price Characteristics and Economics of Gold Price Movements. University of Nottingham.

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