Question

is the equillibrium price in the gold market a good predictor of future inflation rate?Explain

Answer 1

Gold price is not the best indicator of inflation. But it can help in predicting inflation better.

Anticipated inflation has a link to gold returns. The investor would buy gold when the index pointed to a rise in inflation, simultaneously selling holdings of either bonds or equities. When a decline in inflation was
expected, based on analysis of the index, the investor would do the reverse, moving their
assets out of gold. Simply holding gold would have only yielded 14%, while stocks and bonds would have yielded 11% and 8.7% individually.

The successful use of a predictor of inflation to forecast gold prices suggests an asset substitution channel existing
driving gold and inflation into a long run equilibrium relationship. However, the returns seem
to be dominated by a long run appreciation in the gold price .

They show that while including gold in an error correction mechanism does improve forecast accuracy, the improvement is not statistically significant, indicating that gold should not be used as a guide for an inflation-focused
monetary policy.
Much of the discussion on gold link to inflation implicitly assumes that gold is a money-like
commodity. They argue that gold is an inefficient commodity to use as
money. Gold in this model can provide utility, for instance as jewellery, without reducing its
quantity. Therefore those who save using gold but do not gain utility from it through using it
as jewellery etc.

But Gold would allow utility to be gained from holding gold purely as an investment.
The central issue here remains unresolved. Inflation news has been shown to have the
expected effect on gold prices, a positive relationship, so that at least some market participants
trade based on this information as expected.