"Impact of inflation on gold"
The Impact of Inflation on Gold Prices In Pakistan SUPERVISED BY: Sir. Rashid Sattar SUBMITTED BY: Muhammad Faheem Roll No: 13 Ali Awais Khalid Roll No: 62 M.Sc. (Business Economics) Session (2008-2010) DEPARTMENT OF ECONOMICS, The Islamia University of Bahawalpur Pakistan 1 DEDICATED TO: ALMIGHTY ALLAH, HOLLY PROPHET (PBUH), MY FATHER AND MOST VALUABLE ASSET IN MY LIFE TO MY MOTHER & MY RESPECTED TEACHER Sir Rashid Sattar 2 ACKNOWLEDGEMENT All praises for Almighty Allah, who enables us to know about certain unknown things in the universe and helps us to overcome a lot of difficulties. All respect for Holy Prophet Muhammad (PBUH) who clearly mentioned the difference of right and wrong path, to ensure the success in our lives. I am deeply indebted and wish my utmost appreciation and gratitude to my research supervisor Sir Rashid Sattar for his encouragement, technical discussion, inspiring guidance, remarkable suggestions, keen interest and constructive criticism which enabled me to complete this research study. I express my thanks to honorable Prof. Dr. Karamat Ali for providing me possible facilities for the completion of this research work. 3 Abstract: Traditional theory implies that the relative price of gold should not be permanently affected by the rate of inflation. A change in the general rate of inflation should, in equilibrium, because an equal change in the rate of inflation for each asset price the experience of the past decade has been very different from the predictions of this theory: the prices of gold have increased by substantially more than the general price level. The present paper presents a simple theoretical model that explains the positive relation between the rate of inflation and the relative price of such real assets as gold. More specifically, in an economy with an income tax, an increase in the expected rate of inflation causes an immediate increase in the relative price of gold. 4 Table of Contents Chapters Content Titles Title Page Dedication Acknowledgement Abstract Table of contents Page Numbers 1 2 3 4 5 6 13 14 19 20 20 20 21 22 23 24 25 26 1 1.1 2 3 4 4.1 4.2 4.3 4.4 5 Introduction Objective of study Literature Review Theoritical Framework Research Methodology Hypothesis Sampling Design Regression Analysis Data Analysis Conclusion Appendix-A Appendix-B Bibliography 5 Chapter no 1: The Problem and Its Background Introduction: Gold is a comparatively dense, shiny, yellow metal. As an element, gold is quite resistant to corrosion (by oxygen, but also many other chemicals). There are medical (dentistry), chemical and industrial applications of gold. However, aside these rather limited applications (for which, in fact, gold often can be substituted with other materials like copper, ceramics etc.) the metal is more or less useless. As gold was perceived as an ideal store of wealth, its importance as a medium of exchange in trade grew. Finally lead to this invention of gold currencies. However, instead of exchanging real gold coins, it would be enough to only exchange the right on or the promise of a certain amount of gold. Paper money was born. As a relict times when currencies were backed by gold many financial institutions. Since many other countries linked their own currencies to the Dollar by more or less fix exchange rates, gold was de-facto the world currency. Of all the precious metals, gold is the most popular as an investment. Investors generally buy gold as a hedge or safe haven against any economic, political, social or currency-based crises. These crises include investment market declines, burgeoning national debt, currency failure, inflation, war and social unrest. 6 Inflation: One of the most important economic concepts is inflation. At its most basic level, inflation is simply a rise in prices. Over time, as the cost of goods and services increase, the value of a dollar is going to go down because you won't be able to purchase as much with that dollar as you could have last month or last year. Of course, it seems like the cost of goods are always going up, at least to an extent, even when inflation is thought to be in check. It is important to note that some amount of inflation is considered normal (actually, as we explain below, because of its relationship with unemployment, some inflation is actually desirable). While the annual rate of inflation has fluctuated greatly over the last half century, ranging from nearly zero inflation to 23% inflation, the Fed actively tries to maintain a specific rate of inflation, which is usually 2-3% but can vary depending on circumstances. Deflation (for example, -1%) occurs when prices actually decrease over a period of time. Please note that deflation is not the same as disinflation, which is when the rate of inflation decreases but stays positive (for example, a change from a 3% rate to a 2% rate). 7 Inflation and Your Investments: Inflation is greatly feared by investors because it grinds away at the value of your investments. Put simply, $100 today is not the same as $100 in 1 or 10 years. It is crucial to include measures of expected inflation when calculating your expected return on investment. As the most basic example, if you invest $1000 in a 1-year CD that will return 5% over that year, you will be giving up $1000 right now for $1050 in 1 year. If over the course of that year there is an inflation rate of 6%, the purchasing power of $1000 has decreased by $60, and you have actually lost ground! (Of course, the capital gains taxes you pay on your "gain" will increase this loss.) If you had spent that $1000 instead of investing it, you would have been able to purchase a larger bundle of goods than was possible with the $1050 you earned a year later. However, this is not a suggestion that you spend your money instead of saving it. First, the reasons to save are too numerous to list, but a home and retirement should be enough to inspire you. Given that savings are important, inflation eats away at your purchasing power more if you just put your savings under your mattress than if you had invested it. Now that this issue has been clarified, it is important to be aware of the effects of inflation on your investments. Whenever you can, try to determine your "real rate of return", which is the return you can expect after factoring in the effects of inflation. If you are working with a financial professional, ask him or her for an estimate of the real rate of return of a given investment or portfolio. As explained, inflation can erode the value of cash investments, such as stocks, bonds, and CDs. However, some people believe that investments in real goods, such as a home, are protected from inflation. This is because the value of a real good is determined to a large extent by its intrinsic nature, as opposed to money, 8 Which is valued only for what you can trade it .If inflation is high, the price of a home or a car may simply increase at a similar rate, insulating it from price erosion. The same cannot be said for a 10-year bond. As a result, some investors seek protection from inflation, and investment options which do just that are becoming available. The most popular example is TIPS - Treasury Inflation Protected Securities. These investments are just like bonds except that they are insulated from the effects of inflation. The description above explains why investors follow CPI and PPI reports so closely. In addition to being aware of the current rate of inflation, it is crucial to be aware of what inflation rate the experts are anticipating. Both the value of current investments and the attractiveness of future investments will change depending on the outlook for inflation. Traditional theory implies that the relative price of consumer goods and of such real assets as land and gold should not be permanently affected by the rate of inflation. A change in the general rate of inflation should, in equilibrium, cause an equal change in the rate of inflation for each asset price. The experience of the past decade has been very different from the predictions of this theory: the prices of land, gold, and other such stores of value have increased by substantially more than the general price level.The present paper presents a simple theoretical model that offers an explanation of the positive relation between the rate of inflation and the relative price of such real assets. 9 More specifically, The analysis here shows that, in an economy with an income tax, an increase in the expected rate of inflation causes an immediate increase in the relative price of such "store of value" real assets.What we have observed in the past decade can thus be understood as both; (1) A series of transitions to higher relative asset prices whenever there was an increase in expected inflation. (2) The traditional rise in these Gold as an inflation hedge: The inflation hedging quality of gold depends on the presence of a stable long term relationship between the rates of inflation. A strong co integration relationship exists between gold and inflation and it suggest that gold is useful inflation hedge. The result support to widely view that direct and indirect gold investment can serve as an effective inflationary hedge. Of all the precious metals, gold is the most popular as an investment. Investors generally buy gold as a hedge or safe haven against any economic, political, social or currency-based crises. These crises include investment market declines, burgeoning national debt, currency failure, inflation, war and social unrest. Investors also buy gold early in a bull market and aim to sell it before a bear market begins, in an attempt to gain financially. 10 Factors influencing the gold price; Bank failures: When dollars were fully convertible into gold, both were regarded as money. However, most people preferred to carry around paper banknotes rather than the somewhat heavier and less divisible gold coins. If people feared their bank would fail, a bank run might have been the result. This is what happened in the USA during the Great Depression of the 1930s, leading President Roosevelt to impose a national emergency and to outlaw the ownership of gold by US citizens. Low or negative real interest rates: If the return on bonds, equities and real estate is not adequately compensating for risk and inflation then the demand for gold and other alternative investments such as commodities increases. An example of this is the period of Stagflation that occurred during the 1970s and which led to an economic bubble forming in precious metals. War, invasion, looting, crisis: In times of national crisis, people fear that their assets may be seized and that the currency may become worthless. They see gold as a solid asset which will always buy food or transportation. Thus in times of great uncertainty, particularly when war is feared, the demand for gold rises. 11 Demand and supply of gold: Like any other good, gold's price depends on supply and demand. But unlike wheat, say, where most of the current supply comes from this year's crop, gold is storable and most of the supply comes from past production accumulated over centuries. In economists' jargon, the current stock far exceeds this year's flow. Of the total world supply of 125,000 metric tons of gold, annual production ranges around 2,400 tons. This means that in contrast to soybeans, corn, or pork bellies, this year's gold production has little influence on prices. In this sense, gold behaves less like a commodity than like longlived assets such as stocks or bonds. That characteristic makes expectations market, gold particularly prices are important because, and like the stock price forward-looking, today's depends heavily on future demand and supply. 12 1.1: Research Objective: 1) To find out the Impact of inflation on Gold Prices. 2) To find out the strength of Relationship among Inflation and gold prices. 3) To Find out Dependency of Inflation on Gold Prices. 4) To predict the future gold rates with the help of inflation indicator. 13 Chapter 2: Review of Related Literature Author: Greg Tkackz Year: 2007 Author finds that gold contains significant information for future inflation for several countries, especially for those that have adopted formal inflation targets. This finding may arise from the manner in which inflation expectations are formed in these countries, which may result in more rapidly mean-reverting inflation rates. Compared to other inflation indicators for Canada, gold remains statistically significant when combined with variables such as the output gap or the growth rate of a broad monetary aggregate. Author: M. Feldstein Year : 1980 Author analyze Traditional theory implies that the relative price of consumer goods and of such real assets as land and gold should not be permanently affected by the rate of inflation. A change in the general rate of inflation should, in equilibrium, cause an equal change in the rate of inflation for each asset price. The experience of the past decade has been very different from the predictions of this theory: the prices of land, gold, and other such stores of value have increased by substantially more than the general price level. The present paper presents a simple theoretical model that explains the positive relation between the rate of inflation and the relative price of such real assets. 14 Author: J. Neill Fortune Year: 1984 Author relate inflation rate of the price of gold to expected consumer and wholesale prices and to expected interest rates through substitution effects. An increase in expected future prices may induce individuals to convert their current “liquid” assets into gold. Increases in expected interest rates will cause a negative adjustment of the price of gold. The model is used to correctly predict the direction of the change in the price of gold, although the magnitude of the change is somewhat overestimated. Author : Martin Feldstein Year: 1981 Author Analyze that Traditional theory implies that the relative price of consumer goods and of such real assets as land and gold should not be permanently affected by the rate of inflation. A change in the general rate of inflation should, in equilibrium, cause an equal change in the rate of inflation for each asset price The experience of the past decade has been very different from the predictions of this theory: the prices of land, gold, and other such stores of value have increased by substantially more than the general price level. Author: Joseph G. Haubrich Year : 1998 Author finds that the price of gold commands attention because it serves as an indicator of general price stability or inflation. But gold is also a commodity, used in jewelry and by industry, so demand and supply affect its pricing and need to be considered when gold is a factor in monetary policy decisions. 15 Author: Zhou, Su, Mahdavi, Saeid Year : 1997 Author Performs A historical check of using gold and commodity prices as leading inflation indicators reveals that the emphasis on gold as inflation indicator is misplaced with the eclectic integration of the consumer price index (CPI) and that the commodity price index is preferred. The study also reveals that error correction for CPI and commodity price indicators are insignificant in improving predictive performance. Author: Day, Timon Year: 1998 Author analyse that Gold has become less important as a store of value since inflation has been subdued. Gold is being sold to pay the debts of Asian countries and the European Central Bank will only hold a small proportion of its reserves in gold. Optimists see a reduction in sales of gold by central banks leading to a change in investors' perceptions of gold. Gold is more liquid than many other types of investment such as real estate and forestry, and it has uniformity of value. The long term future of gold is more promising than the short term prospects for the market, which depend greatly on central bank sales. 16 Author: Michael D. Bordo Year : 2007 The classical gold standard has long been associated with longrun price stability. But short-run price variability led critics of the gold standard to propose reforms that look much like modern versions of price-path targeting. This paper uses a dynamic stochastic general equilibrium model to examine price dynamics under alternative policy regimes. In the model, a pure inflation target provides more short-run price stability than does the gold standard and, although it introduces a unit root into the price level, it leads to as much long-term price stability as does the gold standard for horizons shorter than 20 years. Relative to these regimes, Fisher's compensated dollar (or pure price-path targeting) reduces inflation uncertainty by an order of magnitude at all horizons. Author: Andrew C. Worthington & Mosayeb Pahlavani Year: 2007 Author finds that the inflation hedging quality of gold depends on the presence of a stable long term relationship between the prices of gold and the rate of inflation. A strong co integration relationship exists between gold and inflation and it suggests that gold is a useful inflation hedge. The results show that direct and indirect gold investment can serve as an effective Inflationary hedge. 17 Author: Dipak Ghosh, Eric j. Levin Year : 2000 Author Analyze contradiction between short run and long run movement on price of gold. Theoritical model tells us that the Prices of gold to rise over time at the general rate of inflation and hence be an effective long run hedge against inflation.In short run changes in gold lease rate, the real interest rate, default risk, the covariance of gold returns with other assets such as dollar and exchange rate can seriously disturb this equilibrium relationship and generate short run price volatility. Author: Rob h. Kamery Year: 1986 Author analyze that this article simply tells us the relationship between gold, inflation and the federal reserve,s economic policies from a historical view point. The conclusion supported by historical evidence will show that price of gold is not a reliable qualitative indicator. 18 Chapter 3: Theoretical Frame work Now after the understanding of the problem we develop a framework that how the different factors that have been identified as important to research in the problem area, are related to each other. The dependent variables are influenced by the one independent variable. Independent variable: Inflation Dependent Variables: Gold Prices 3 .1: Independent Variable : Inflation In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services; a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time. In our study inflation is independent variables. 3.2: Dependent variable: Gold Prices : Gold is a precious metal used in most countries as a currency. And gold is kept as a foreign reserve in most of countries because it is used as currency and it is real money, there is no chance of devaluation of gold because It is not fiat money.Gold Prices are dependent on inflation. 19 Chapter 4: Research Methodology The section of a research proposal in which the methods to be used are described. The research design, the population to be studied, and the research instruments, or tools, to be used are discussed in the methodology. 4.1: Hypothesis: Some explicit statements used to check significance of our research. These are not Part of our results. (a)Null Hypothesis Hº: There is no link between Inflation And gold Prices. (b)Alternate Hypothesis H¹: There is link between Inflation and gold Prices. 4.2 : Sampling Design: In Our Research issue we uses secondary data so there is no need of sampling Design.Our Population Is Pakistan so we analyse hisotrical data of Inflation and Gold Prices.We analyse Past 10 years of data for analysis between inflation and gold Prices. 4.3: Research Design: Research design shows what statistical techniques we use for our research. We use regression analysis by computer software to find out significance of or data. 20 4.3(A): Regression Analysis: Regression analysis includes any techniques for modeling and analyzing several variables, when the focus is on the relationship between a dependent variable and one or more independent variables. More specifically, regression analysis helps us understand how the typical value of the dependent variable changes when any one of the independent variables is varied, while the other independent variables are held fixed. 4.3(B): Development of Model: Y=a+bx+u Gold Price= 1817.054+944.009 Inflation r square=0.62 Where: (a) Gold Price is dependent variable. (b) Inflation is dependent variable. 21 4.4. Data Analysis: Appendix –A which is shown below shows following findings we interpret below, 1) F-Static : 18.843 which is significant at 0% level. 2) The coefficient for inflation also significant at 0% level. 3) Coefficient of inflation has Positive sign which shows Inflation is Positively Related with Gold Prices . 4) r square=0.62 which shows 62% variation in Gold Prices is due to Inflation. 5) 62% is explained variation in gold due to inflation and 38% is unexplained variation due to others factors. 22 Chapter 5: Conclusion and Summary 5.1. Conclusion: The purpose of this study is to develop an empirical model of the impact of inflation on gold rates. We have sued ordinary least square method to regress our model. We find that their positive relationship between inflation and gold prices. In our study we take time series data form 1997 to 2009 the empirical result of the estimation of the gold rate model was presented all the results are significant at 1%. 23 Appendices Appendix -A Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Inflation Gold Prices (10gm) 11.8 7.8 5.7 3.6 4.4 3.5 3.1 4.6 9.3 7.9 7.8 12.8 22.3 4360 4625 4621 4946 5391 5960 6814 7711 8518 11885 13564 19941 24029 24 Appendix -B Regression Variables Entered/Removed (b) Model 1 Variables Entered inflation(a) Variables Removed . Method Enter All requested variables entered. B: Dependent Variable: gold price Model Summary Adjusted R Std. Error of the Square Estimate .595 4014.53 Model 1 R .793(a) R Square .629 Predictors: (Constant), inflation ANOVA (b) Model 1 Sum of Squares Regression Residual Total 300454045.711 177281207.058 477735252.769 df 1 11 12 Mean Square 300454045.711 16116473.369 F 18.643 Sig. .001(a) Predictors: (Constant), inflation B: Dependent Variable: gold price Coefficients (a) Unstandardized Coefficients Model 1 Standardized Coefficients T Sig. (Constant) inflation B 1817.054 944.009 Std. Error 2081.932 218.636 Beta .793 B .873 4.318 Std. 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