Question

You read in a magazine that economic theory suggests the price of gold should be the same in every country. Describe the theory from international finance that links prices across countries. Explain three reasons why you might not expect this theory to hold in practice.

Answer 1

Reasons

1.Consumption demand
Demand for gold in India is interwoven with culture, tradition, the desire for beauty and the desire for financial protection.

2.Protection against volatility
People want to invest or buy gold to protect themselves from volatility and uncertainty. The preference for physical assets makes Indian households view gold as a safe haven, an asset to buy when other assets are losing value. Underlining gold's attraction as an asset for good times and bad, most investors would buy gold whether the domestic economy was growing or in recession

3.Gold and inflation
When inflation rises, the value of currency goes down and therefore people tend to hold money in the form of gold. Therefore, in times when inflation remains high over a longer period, gold becomes a tool to hedge against inflationary conditions. This pushes gold prices higher in the inflationary period.

4.Gold and interest rates
According to some industry experts, under normal circumstances, there is a negative relationship between gold and interest rates. Rising yield indicates an expectation of strong economy. Strong economy gives rise to inflation and gold is used as a hedge against inflation. Also, when rates rise, investors flock to fixed-income investments that yield a fixed return unlike gold which does not carry any such return. So, demand takes a back seat with prices remaining flat.

5.Impact of rupee-dollar equation
The rupee-dollar equation has a role to play in Indian gold rates although it does not impact global gold prices. Gold is largely imported and hence if the rupee weakens against the dollar, gold prices will likely appreciate in rupee terms. So, a deprecating rupee may dent the demand of gold in the country. However, remember the change in rupee-dollar rates has no impact on gold rates denominated in dollars