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Economists assume that the price of gold, though uncertain, is estimable. They approach the estimation like that of any other commodity with rising production costs.
Gold specialists and dealers, in contrast, follow an older economic convention that stresses the monetary roles of existing gold stocks, which exceed annual new metal- output by two orders of magnitude. The price of gold is thought to be based largely on expectations of shifts in international macroeconomic variables and world trade.
Neither of these approaches has yielded good price predictions. The basic problem is that Investment demands cannot be treated simply as modifications of producers’ inventories for precautionary or speculative purposes. as with other commodities. Thus if we claim fabricated demands should increase proportionately with world gross national product (GNP), with Leontief et al., we get forecasts of annual world gold consumption in year 2000 that are ridiculously high. viz., two or three times 1980 outputs. If we had to supply such increases from new gold production it would require increases in real gold prices to $600 or $1,000 per ounce in constant-dollar terms.
Clearly these estimates are inconsistent with the past patterns of change in fabricated- gold supplies and demands, which give evidence of considerable sensitivity to changes in price (price elasticity’s). This suggests to market experts that they reexamine gold’s role as a premier store of value whose price responds less to movements in fabricated- products and new gold production costs than to changes in stock holdings of previously mined gold. Such asset holdings respond largely to changes in asset prices, i.e. the rates of interest, inflation, and foreign exchange. Because prices are influenced by shifts in macroeconomic variables, this second approach attempts to correlate gold prices directly to monetary variables, but it has been no more successful than the commodity approach.
One reason for failure is that changes in the stock holdings of gold complicate inter- national capital movements. Capital movements are driven by expectations of changes in asset prices, and these are sensitive to uncertainty about monetary policies. These complications discourage and confuse attempts to employ statistical analyses directly to explain gold price movements.
We suggest treating gold as a stock price for foreign assets in the portfolios of international investors averse to currency risks. Gold’s own price, the exchange rate, the price level and the rate of interest are shown as substitute asset prices which enter with other exogenous variables and wealth in the demands of private and public investors here and abroad. These investors maximize utility subject to the constraints of monetary policy and balance of payments disequilibrium. As investors seek to maintain desired levels of different asset holdings, foreign and domestic, the markets for bullion or shares of gold production respond according to the conditional expectations of changes in the key rates and uncertainties affecting the value of home-country currency. The challenge of this hypothesis is to find a way to test it empirically.
A way around the difficulty is given by mining share exchanges. Since bullion and shares of gold mining firms are gross substitutes, the use of capital-asset-pricing theory permits us a simple test of this alternative model in application to North American gold producers whose shares trade on the stock exchange.
Our results show that trends in new gold-production and price movements are not simple functions of commodity forecasts by conventional gold-market analysis. Gold is better forecast as a stock price determined by stock exchange. This implies a much more volatile market whenever monetary expectations become dominant. Such periods are demonstrated by the size of the premium which prevails for gold above its production price. This can be two to three times higher than normal, enough to discourage the growth of fabricated significantly. About this premium level, irregular price cycles arise from movements in stock positions among investors during periods of adjustment to world monetary disequilibrium. The variance in price is related to the sensitivity of fabricated demands to price. We show that investors who monitor macro-economic variables in a fully identified model can successfully hedge against currency devaluations and gamer capital gains periodically through a strategy that includes gold securities in their investment portfolios.
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