Supply, demand, and investor behavior… that seems simple enough. However, the way these factors work together to affect the price of gold can sometimes be counterintuitive. Let’s dive in.

How does the relationship to inflation & market confidence affect gold?

Studies show that gold prices have positive price elasticity, meaning its value increases along with demand. As with any asset with positive price elasticity, the more investors turn to gold, the greater the price is driven upward. What’s unique for gold is the correlation between low market confidence and high demand. This combination causes the gold price to perform well under both good and bad economic conditions: it maintains value when the economy is healthy and increases in value when the economy is troubled.

History has proven that investors flock to gold in times of financial crisis. When the Great Recession hit, for instance, gold prices increased. Gold was already rising in value up to the start of 2008, approaching $1,000 an ounce, before rising as the stock market bottomed out. Gold continued to rise even further even as the economy started to recover. The price of gold peaked in 2011 at $1,825 with the cheapest physical gold products at $1,950.

How does gold supply affect the price of gold?

Gold is both a monetary instrument and a global commodity, much like oil or coffee. However, unlike those commodities, gold is not consumed: Almost all of the gold ever mined still exists, and more gold is being mined every day. At first glance, this might make you think that, over time, the price of gold would decrease due to the continuous supply, but looking back through history we clearly see that isn’t the case. How come?

Aside from the fact that the number of people wanting to buy gold is increasing at an even faster rate than the supply of gold, jewelry and investment demand offers an interesting insight. Most gold is held for a very long time after purchase—it’s highly unusual to invest in gold and then quickly sell it. The same goes for gold jewelry—people are more likely to put it in a drawer or pass it down to a family member than cashing it in for a new TV. 

What role do central banks play for gold prices?

Central banks are a major factor when gold prices are decreasing. During times when foreign exchange reserves are large and the economy is buzzing along, a central bank will sometimes decide to exchange the gold it holds for a high-growth asset. This is because, at the end of the day, central banks are still businesses that are expected to make money, not to play it safe or maintain status quo.

The problem they face is that this is exactly when other investors out there aren’t as interested in gold. Therefore, central banks typically find themselves on the wrong side of the trade, selling gold when there is not the highest level of interest from buyers.

Central banks are, not surprisingly, aware of this fact, so they take careful steps to manage their gold sales in a manner to maximize their portfolios or the markets. In fact, there is something called The Washington Agreement, which essentially states that the central bank of each country will not sell more than 400 metric tons of gold in a year. Signed on September 26, 1999, by 13 nations, this agreement is highly respected between the parties involved, and it was strengthened in 2004 and extended in 2009. 

Gold retains value

Since gold has been an important part of society for thousands of years, we can simply look through history to analyze and understand its ability to retain value. 

Let’s compare the salary of Roman soldiers 2,000 years ago to what a modern soldier would get today, based on how much those salaries would be in gold. Roman centurions (officer rank) received 38.58 ounces of gold per year.

Assuming $1,800 per ounce, a Roman centurion (roughly equivalent to a captain) received $69,444 per year, while a US Army captain today gets $52,596 or 29.22 ounces at $1,800 per ounce. Seems like salary conditions for senior military staff have worsened through the years. Or is it really that the value of gold grows over time (see more about this below), and by paying the military with paper currency and not gold, governments have found a way to effectively get them for much less.

However, as the salaries are not that far apart, we can see that the purchasing power of gold has stayed consistent over thousands of years and holds value beyond its market price. 

Gold gains in value

However, gold not only preserves purchasing power, it tends to even increase it. This is one of the biggest secrets of the investment world and one that dictates that holding gold is even more beneficial when it’s a long-term investment. Some say that this tendency of gold is evidence that the government’s inflation numbers are too low. The hidden inflation is reflected in the price of gold rising higher than expected. 

Others say that since technological advancements lower the cost of production and therefore also the price of goods, we should see an increase in the purchasing power of gold. Think about it: What asset do you know that has a built-in mechanism to gain in value over time? One that’s been proven for over 5,000 years.

If we compare the purchasing power of gold to that of the US dollar, it becomes pretty clear how strong an asset gold is:

The Bottom Line

When looking at gold prices, a great place to start is the current state of the economy and where you think it’s headed. As economic conditions worsen, the price of gold will typically rise.

The world’s smartest investors are always diversified in gold because we never know when the economy will deteriorate and to what extent, and it’s virtually impossible to time the markets. Keeping gold as a hedge in a percentage that is large enough to provide insurance and protection when the economy or the markets deteriorate provides the investor with peace of mind and improved performance by reducing their losses and the volatility of their portfolio, thus providing increased stability and security.