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Short Run and Long Run Determinants of the price of gold

by on March 12, 2012

This 2007 paper, published by the World Gold Council, analyses what drives the price of gold at a fundamental level, its supply and demand. It develops both a detailed and logical theory as to the determinants of the short and long run drivers of the price of gold and then tests how it fits the data over a 30 year period. Below is a summary its contributions.

Section 2: Gold’s varying ability to hedge against inflation is shown graphically for a large number of gold producing and consuming countries. While in the short run there are significant deviations from its inflation adjusted value in the long run the relationship between the domestic price of gold and its domestic inflation adjusted price is seen to return to equilibrium.

Section 3: This section gives a detailed description of the theoretical factors that would affect the supply and demand for a gold in the short and long run.

Supply is:

1)+ly related to the lagged gold price as mines increase production in response to higher gold prices.
2)-ly related to the amount leased in the last period as this amount must be repaid
 
Levin and Wright point out that the amount leased in the previous period is a function of the convenience yield on gold (the benefit of holding physical gold over owning a contract to buy in the future), the default risk of the transaction and the lease rate itself.

Demand is:

1)a function of use demand; Jewellery, Electronics etc., which is –ly related to price,
2)-ly related to dollar exchange rate expectations,
3)+ly related to inflation expectations,
4)+ly related to fear,
5)+ly related to a lack of correlation with other assets, which is related to current and lagged values of gold’s beta,
6)-ly returns offered by alternative assets, specifically the real interest rate, as this is the opportunity cost of holding gold.

The S-R Gold Price is then seen to diverge from its long run path due to the following of the above variables: Political and Financial turmoil (Fear), Changes in the real rate of interest and changes in the beta of gold.

The authors argue that the L-R Gold Price should rise with inflation as in the long run the price should rise with the cost of extraction. So that if production costs move in line with inflation the LR price of gold will too.

Method: Co integration, Error Correction Models, Economic Theory

Data:

Monthly data from January 1976 – August 05
Monthly average spot price of gold from Kitco
Inflation from the US Department of Labour Statistics
World Price level from IMF World Consumer Price Index
Nominal Major Currencies Dollar index

Full Citation: Levin, E. and Wright, R. (2006). “Short Run and Long Run Determinants of the price of gold.” World Gold Council, Research Study 32.

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