Rational Bubbles in the Price of Gold (1984)
This 1984 paper analyses whether rational bubbles occur in the real price of gold. To do this it develops a model of the statistical properties of a time series of an asset price containing bubbles would look like and then tests for its presence in gold. They find that the price of gold over the period is determined by fundamental factors i.e. that no bubble is present.
The fundamental factor used is the US real interest rate, as a proxy for the opportunity cost of holding gold. A negative relationship should be present as it becomes more expensive to hold a non interest bearing asset such as gold when real interest rates rise. This paper predates the organised London leasing market for gold.
Theoretical Contribution: The authors develop a model for the portfolio demand for gold showing the value of the stock of gold as a function of two fundamental factors: the expected change in the price of gold (+) and the return on other assets (-). From this they show that if both factors are stationary (have a mean, finite variance etc.) then the price of gold will also be stationary. If the factors have to be differenced n times to become stationary, and the price of gold differenced n times is also stationary then the price is determined by fundamentals with no bubble is present.
This is due to the fact that bubble factors are nonstationary regardless of how many times it is differenced. If the price of gold needs to be differenced more times than the fundamental factors to become stationary then a bubble may be.
Method: Ordinary Least Squares regressions. Autocorrelation functions. Tests for Stationarity.
Data: Monthly average price of the PM Fixings price divided by CPI from 1975 – 1983 (99 observations).
Real interest of one month US commercial paper less US CPI.
Abstract: This paper describes a theoretical and empirical study of the possibility of rational bubbles in the relative price of gold. The critical implication of the theoretical analysis is that, if rational bubbles exist, the time series of the relative price of gold, as well as any other time series obtained by differencing a finite number of times is non-stationary. The evidence is consistent with the combined conclusion that the relative price of gold corresponds to market fundamentals, that the process generating the first difference of market fundaments is stationary, and that actual price movements do not involve rational bubbles.
Full Citation: Diba, B. T. and Grossman, H. I. (1984). Rational Bubbles in the Price of Gold. NBER working paper no. 1300.