2.1 INTRODUCTION

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 research 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.

2.2 IMPACTS OF INFLATION

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.

2.3 IMPACTS OF EXCHANGE RATE

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), h