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Literature Review Focusing On Determinants Of Gold Price


In Chapter One—Introduction, we have introduced about gold, international monetary system, and the influences of gold prices in the world. We have defined research questions, research objectives, significance of study, and scope of study.

In Chapter Two—Literature Review, we are going to look into the researches done on determinants of gold price, which are inflation rate, exchange rate, and demand& supply factors. In these fields, there have been a number of researches done based on different purposes, such as the influence of inflation rate on GDP, impacts of exchange rate on international trade, influences of demand & supply factors on gold price, and so forth. Thus, we are going to investigate how these factors are influencing gold as a medium to reduce investment risks.


Dipak et al. (2002) published a paper in researching gold as an inflation hedge. He has explained that inflation hedge price is the dollar price that gold would have to be in order to maintain its purchasing power. In his findings, the nominal price of gold was $384 per ounce in January 1982 and $283 in December 1999. He concluded that gold was not a short-run inflation hedge between these years. He had suggested, from his theoretical model, that sizeable short-run movements in the price of gold are consistent with the gold price rising over the time with the general rate of inflation. In addition, from the monthly gold price analysis data (1976-1999) and co-integration regression techniques provided by Dipak et al. (2002) have confirmed that gold can be regarded as a long-run inflation hedge and the movements in the nominal price of gold are dominated by short-run influences. Chart 2.1 plots the phenomenon described by Dijak et al. (2002).

Chart 2.1: The US Dollar Price of Gold Required for Gold to be an inflation Hedge in the United States, 1985-1999. Source: Dijak et al. (2002) “Gold as an Inflation Hedge?”

Later on, Worthington& Pahlavani (2006) also conducted a study on gold investment and inflation hedge, and they published it with the title “Gold Investment as an inflationary hedge: Co-integration evidence with allowance for endogenous structural breaks”. They used the monthly price of gold and inflation in the United States from 1945 to 2006 and from 1973 to 2006, which was newer than the data presented by Dijak et al. (2002). Furthermore, they were stressed that their analysis in using monthly gold price data (1976-1999) and co-integration regression techniques provides empirical confirmation that gold can be regarded as a long-run inflation hedge. They were concluded that inflation hedging quality of gold depends on the presence of a stable long-term relationship between the price of gold and the rate of inflation.

Eric J Levin and Robert E Wright (2006) studied about the determinants of the price of gold in short-run and long-run. According to Eric and Robert (2006), they developed a theoretical framework based on the simple economics of “supply and demand” that is consistent with the view that gold is an inflation hedge in the long-run and it also allows the price of gold to fluctuate considerably in the short run. They stated three findings in their papers. The first finding is that there is a long-term relationship between the price of gold and the US price level, followed by second finding, which is the US price level and the price of gold moved together in a statistically significant long-run relationship supporting the view of that one percent increase in the general US price level leads to a one percent increase in the price of gold. Thirdly, they were stated that, in the wake of a shock that causes a deviation from this long-term relationship, there is a slow reversion back towards it. In this paper, they were concluded that there is a long term one-for-one relationship between the price of gold and general price level in the USA. In other words, one percent rise in US inflation raises the long-term price of gold by an estimated one percent. Despite of this, there are short-run deviations from the long-run relationship between the price of gold caused by short-run changes in the US inflationary rate, inflation volatility, credit risk, the US dollar trade-weighted exchange rate and the gold lease rate. In addition, third finding has been proven as there is a slow reversion towards the long-term relationship following a shock that cause a deviation from this long-term relationship.

In fact, all of the above empirical studies focused on the direct relationship between inflation and the price of gold. The empirical studies below focused on the indirect relationship between inflation and the price of gold, such as inflation and investments, inflation and performance of stock markets, and so forth.

John H. Boyd, Ross Levine, and Bruce D. Smith (2000) studied about the impact of inflation on financial sector performance. In this paper, they empirically assessed the predictions of the rate of inflation interfere with the ability of the financial sector to allocate resources effectively. They had quoted from Huybens (1998) and Smith (1999); recent theories emphasize the importance of informational asymmetries in credit market and demonstrate how increases in the rate of inflation adversely affect credit market frictions with negative repercussions for finance sectors performance and therefore long-run real activity. Furthermore, they quoted from Boyd and Smith (1998); Huybens and Smith (1998, 1999) that the related models suggest the existence of a third inflation threshold. According to this threshold, in some cases, once the rate of inflation exceeds the critical level, perfect foreign dynamics do not allow an economy to converge to a steady state displaying either an active financial system or a high level of real activity. In other words, further increase in inflation after exceeding the critical level will have no additional consequences for financial sector performance or economic growth. Throughout this paper, they had shown the evidence that indicates that there is a significant and economically important, negative relationship between inflation and financial development. Furthermore, they also found that the empirical relationship between inflation and financial sector activity is highly non-linear. One of the examples provided by John et al (2000) is that in low-inflation countries, the data indicates that more inflation is not matched by greater nominal equity returns. John et al (2000) stress that this finding is consistent with the theories outlined in the Introduction of his paper.

Mohammed Omran and John Pointon (2001) conducted a research in determining whether inflation rate affect the performance of the stock markets. In this paper, they were examining the impact of inflation rate based on the performance of Egyptian stock market. They also paid attention to the effects of the rate of inflation on various stock market performance variables in terms of market activity and market liquidity. According to Mohammed and John (2001), the results revealed an expected behavior for the stock market response to the decrease in the inflation rate, and the results regarding overall performance seem consistent as there is an inverse relationship between the inflation rate and both stock returns and prices.

Patrick Honohan and Philip R. Lane (2004) of The World Bank and Economic Department discussed about the exchange rate and inflation under Economic and Monetary Unition, EMU. The purpose of this paper is to provide updated information from their previous work, which was about the exchange rate and inflation under EMU. In this paper, they updated and extended the exchange rates matter for EMU inflation rates during periods of euro appreciation (2002-2003) as well as periods of euro depreciation (1991-2001). Next, they were also provided an analysis of quarterly data over 1999.1-2004.1. They confirmed the connection between exchange rates and inflation. When the exchange rate is excessively weak, inflation rises in order to correct under-valuation, or vice versa.

M. Kannadhasan (2006) is concerned about the effects of inflation on capital budgeting decisions. In his research paper, ‘Effects of Inflation On Capital Budgeting Decisions—An Analytical Study’, he stated that in practice, managers do recognize that inflation exists but rarely incorporate inflation in the analysis of capital budgeting because they were assuming that with inflation, both net revenues and the project cost will rise proportionately. However, it was incorrect. In the purpose of presenting the correct path, he had divided his research paper into two parts: discussion about inflation, how to measure inflation and the effects of inflation on GDP, and the second part, effects on inflation on capital budgeting decisions, concerning about how to deal with expected and unexpected inflation while forecasting cash flows and determining the discount rate in particular. According to M. Kannadhasan (2006), inflation is measured by observing the change in the price of a large number of goods and services in an economy, and it is usually based on data collected by government agencies. As similar to other explanation, he had explained that inflation rate is the rate of increasing in the price index. He had described price level as measuring the size of the balloon, while inflation refers to the increase in its size. In his findings, he had concluded that effects of inflation are significantly influenced on capital budgeting decision making process. He was also recommended that finance manager should take into organize the effects of inflation.

Dorel Bercanu and Anca Bandoi (2009) have done their research in investigating how inflation influences about investment decision. They had stated that the activity of investment in a company is based on strategy of economic development set at the level it held and also based on the investment programs or projects. Meanwhile they defined the meaning of project investment as a complete and autonomous action involving the achievement of its investments and exploitation of its long life. They have stated that inflation represents the accelerated growth and the general level of prices, matched by increased money, low purchasing power of money and depreciation under the influence of economic, monetary, social, domestic and foreign policy. As discussed in Chapter One, we knew that international monetary system started with the backup of gold standard, and thus, the increasing of inflation rate can positively or negatively influence the price of gold. Dorel and Anca (2009), used simple criteria or criteria based on discounting the present value criteria (NPV). Through data analysis, they concluded that in taking decisions in investments, investors should take the influence of inflation into account and thus, right decision could be made.


According to Mika& Eero (2007), evidence indicated that the US Inflation, world inflation volatility, US-world exchange rate index, beta of gold and credit risk default premium were all statistically significant variables. In their research paper, they quoted Capie, F., Mills, T.C. and Wood, G (2004), had examined one aspect of the second role of gold, which is gold as hedge against US dollar. Capie et al (2004) was using data from 1971 to 2002, and then applied a variety of statistical techniques to explore the relationships between gold and the exchange rates of various currencies against the US dollar, with particular attention paid to the hedging properties of gold in episodes of economic or political turmoil. As a result, they were found that US dollar gold price move in opposition to US dollar and the movement was essentially contemporaneous.

Kuan-Min& Yuan-Min (2010) published their research “Could Gold Serve as an Exchange Rate Hedge in Japan?” In this paper, they attempted to examine whether gold could be an exchange rate hedge in Japan using data from 1986 to 2007. According to Kuan-Min& Yuan-Min (2010), most researches have focused on a linear relationship between returns on gold and the exchange rate, but they were using the depreciation rate of the yen as a threshold variable to distinguish between a high depreciation regime and a low depreciation regime. As a result, they were found that when the yen depreciation rate is greater than 2.6%, investing in gold could avoid the depreciation loss.

Bedjo Santoso (2010) studied about the effects of G-8’s GDP, US dollar exchange rate and gold exchange rate to the Indonesian export. G-8 is the largest importer for Indonesian products. G-8 countries are USA, Germany, French, Italy, UK, Italy, Russia, Canada and Japan. In this paper, he examined the implication of G8’s GDP, US dollar exchange rate change, and exchange price of Gold on the demand export of Indonesia. Throughout this study, it is clearly shows that US dollar exchange rate variable has a negatively relationship in the long term with Indonesian export, and it also effects the export volume decrease in the short-run. Despite from it, gold exchange rate and G-8’s GDP have positively and significantly impacts in the long run. Meanwhile, the changing of the variables was adjusted around 6% by export variable in the short run. Furthermore, a positively relationship is found between the volume of exports with gold exchange rates, and it is significant in the short term. According to Bedjo (2010) there is an opportunity for using gold base currency as a better alternative.

All of the empirical studies above had direct relationship between exchange rate and the price of gold. Inversely, the empirical studies below were having indirect relationship between exchange rate and the price of gold. For example, exchange rate strategies on trade and foreign direct investment.

A. Lahrèche-Révil and A. Bénassy-Quéré (2001) conducted a study regarding of the impact of exchange rate strategies on trade and foreign direct investment in China. According to Lahrèche and Bénassy (2001), the research examined the impact of potential changes in the exchange-rate strategy of China on the amount and distribution trade and foreign direct investment in China. They also stated that exchange-rate regimes are defined through the joint behavior of the real exchange rate level and the nominal exchange rate volatility. In this paper, they managed to draw several conclusions. Firstly, they concluded that real exchange rate is likely to be increasing concern for both trade and foreign direct investment in China. Next, exchange-rate regimes play a role for attracting FDI in China although they were unable to successfully demonstrate an influence of exchange-rate uncertainty on trade.

Christian Broda and John Romalis (2003) conducted a study for identifying the relationship between trade and exchange rate volatility. According to Christian and John (2003), a model of international trade in which international trade depresses real exchange rate volatility and exchange rate volatility impacts trade in products differently according to their degree of differentiation. In this study, they were using disaggregate trade data for a large number of countries for the period 1970-1997. Strong results were found in supporting the prediction that trade dampens exchange rate volatility. Christian and John (2003) stressed that their empirical model attributes most to the correlation between trade and volatility to the effect that trade has in depressing volatility. Some evidences about the real exchange rate volatility depress trade in differentiated goods are found in this paper. Thus, we know that real exchange rate have direct relationship in international trade.

Michael W. Klein and Jay C. Shambaugh (2005) conducted a similar study which emphasized in observing fixed exchange rates and trade. In this paper, they used a new data-based classification of fixed exchange rate regimes. As result, it shows a large and significant effect of a fixed exchange rate on bilateral trade between a base country and a country that pegs to it. Furthermore, according to Michael and Jay (2005), these results have suggested an economically relevant role for exchange rate regimes in trade determination since a significant amount of world trade is conducted between countries with fixed exchange rates. In this paper, they were found that with few controls pegging appears to have increase trade by approximately 80%. Thus, we believe that fixed exchange rate does encourage trading as well as gold trading.


According to Dijak et al. (2002),theoretically models verify whether gold can serves as an inflation hedge. Both of the theoretically models were focused in one of the determinants of gold price, which is demand and the supply of gold. The first model was focused in determining the effects of demand and supply of gold in short-run, while second model was focused in determining the effects of demand and supply of gold in long-run. As a result, they determined that in the short-run, demand and supply of gold did not have statistically significant relationship to the price of gold, meanwhile, in the long-run, demand and supply of the gold did have statistically significant relationship to the price of gold.

Furthermore, with the statistic published by WGC (2011) in “Gold Demand Trends” analyzed on the demand of the gold in terms of jewelry, investment, technology, and supply of the gold in terms of mine production, recycled gold, central banks, and gold production. From Table 2.0, it was clearly shown the demand of the gold had increased from 2009 to 2010.

Gold Demand




















OTC and stock flows




London PM fix, $/oz




* Provisional.

Table 2.0: Gold Demand (2009-2010). Source: WGC 2011 ‘Gold Demand Trends’

Gold Supply








Total mine supply







Official sector sales







Recycled gold







Total Supply








Table 2.1: Gold Supply (2009-2010). Source: WGC 2011 ‘Gold Demand Trends’

Table 2.1 above shows the increasing gold supply from quarter 4 in 2009 to quarter 4 in 2010. As a result, the price of the gold had significantly increased from 2009 to 2010 (Juan, 2010).Apart from that, the empirical studies below show how does the demand & supply factors influence on the price level, regardless of the types of products.

Erika Schulz (2005) studied about the influence of supply and demand factors on aggregate health care expenditure with a specific focus on age composition. According to Erika (2005), several studies were done in the past and it has shown that health care expenditure is not only influenced by demand factors, but also by those on the supply side, particularly technological progress, political decisions, and economic framework conditions. In short, it is proven that demand & supply factors are influencing the price level.

Lauren Cohen, Karl B. Diether, Christopher J. Malloy (2006) conducted a research in studying the supply and demand shifts in the shorting market. According to Lauren et al (2006), they employed a unique identification strategy in which isolating the shifts in the supply and demand for shorting. In this paper, they have shown that an increase in shorting demand has economically large and statistically significantly negative effects on future stock returns. However, they are not able to find strong and powerful evidences in supporting the hypothesis that shifts in shorting supply are linked to future returns.

Ronald Trostle (2008) studied about the demand and supply factors in global agricultural field. In his paper, “Global Agricultural Supply and Demand: Factors Contributing to the Recent Increase in Food Commodity Prices”, he was using the data information during the last 2 years, which is from 2006 to 2007. He had identified the factors that influencing the demand and supply of the global food community. According to Ronald (2008), other factors that are influencing the demand and supply of the global food community include the depreciation of U.S. dollar, rising energy prices, increasing agricultural cost of production, growing exchange holdings, and so forth. Thus we could foresee that demand and supply factors have direct relationship to the goods.

Navee Chiadamrong (2010) conducted a study in evaluating the economic impact of demand, supply and process uncertainty in a retail chain. According to Navee (2010), the aim of this study is to examine the relationship between uncertainty in both demand and supply sides, and economic impact in a retail supply chain. He had further elaborated that these uncertainties increase the risk within the chains, and defined risk as a consequences of the external and internal uncertainties that affect a supply chain. Throughout the study, the results indicate that the elimination of uncertainty can reduce supply chain costs while boost the profitability.


According to Antal (2005), gold is the ultimate distinguisher of debt. Gold is universally acceptable and it can be uses for variety functions. Keeping gold enables people to protect themselves from the collapse of fiat money system and also put pressures on the banks and the government through demanding gold. After the collapse of Bretton Woods System, gold is no longer redeemable as people have lost their ability in protecting their rights and freedoms inherent in a gold standard.

In addition, T. Rowe Price (2010) had listed the factors that are impacting the price of gold. Among the listed factors, inflation rates, demand for physical gold and Exchange Traded Funds, Growth in Emerging markets were concerned in this paper. Apart from that, some of the listed factors are closely related to the reasons for using gold as a medium in reducing investment risks, which are sovereign debt concerns, U.S. fiscal concerns, and the disappointment with traditional asset classes.

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