Price Elasticity of Demand for Gold - Example

ECONOMICS Contents Introduction 3 Gold, Long a Secure Investment, Loses Its Luster: Background overview 3 Demand and Supply Analysis 5 Gold looses its luster: Rational behind plunge in gold prices 6 Price elasticity of demand for gold 8 9 Strategic decisions for investment in gold 9 Conclusion 11 References 11 Introduction The prices of gold have gone through the phases of boom and bust over the last thirty years. The gold prices hit the lowest figure in 1980s. Since then the world economy has passed through several stages of crisis including inflation, debt crisis, housing market crisis, financial recession, etc. The weaker performance of the economic index led to rising demand for gold and the prices of gold increased. The recovering signs of the world economy due to good performance by the policymakers led to the fall of gold prices as the demand for gold fell due to higher return on investment in other class of assets. Gold, Long a Secure Investment, Loses Its Luster: Background overview During the period of economic recession, the prices of gold soared and became the sought after investment for the investors. The rise in the prices of gold meant that the world economy was not performing well. Due to the economic recession and the global financial meltdown from 2008 to 2011, the gold prices reached its highest peak in 2011. This could be observed from the producer price index as given below. Due to the crisis in the economy, the total factor productivity of the nations was hit and the factors of production were affected due to the downturn of the economies. The crisis in the economy gave rise to a situation of liquidity crisis. The fall in income levels of the people led to the fall in consumption demand in the economy. Due to this, the productivity of the business houses and industrial bodies fell. The fall in revenue and profitability led to the erosion of wealth of the shareholders and market investors. Along with this the erosion of confidence of the investors on the stock performance of the companies led to the fall of valuation of the companies and market indices. As a replacement for the investment in stock markets, the investors confided on the investment in gold markets (McGuire, 2010, p.37)1. The investment in gold was considered to be lucrative as prices of gold increased on the back of high demand for gold. An investment in gold offered higher returns on investment and there was no erosion of wealth from the amount of investment. Apart from that gold could be sold at any point of time and was considered as marketable investment. The presence of large number of buyers gave the opportunity to transform it into cash at any point of time. All these factors led to the rise in the prices of gold. Investment in gold was deemed to be an investment that would in which the returns obtained would never be lowered (Northcott, 2010, p.46)2. The spurt in he gold prices over the last few years fuelled by weak economic conditions has been represented below. Demand and Supply Analysis The fluctuation in the price of gold could be explained from the demand supply curve for gold as given below. As the demand for gold rose in a weaker economic condition, the demand curve shifted from position 1 to 2 depicted by the red line. As a result, in order to maintain a position of equilibrium with the supply, the prices of gold rose from P1 to P2. The reverse is also true for fall in prices for gold as a result of fall in demand. Gold looses its luster: Rational behind plunge in gold prices The unexpected plunge in the prices of gold in recent times has occurred as result of recovery in the performance of the economies all over the world. The correct strategies adopted by the policymakers in order to maintain a proper balance of supply and demand in the economy, controlling inflation through appropriate interest rates, fiscal and monetary policies have led to turn around of the economies of the world. The economic reforms and recovery from the economic recession led to improvement in the performance of stocks for which the prices of gold started to dip from 2011. This has been represented in the graphical diagram for gold prices as given below. From a record high in 2011, the gold prices reached its lowest rate in April, 2013. During the time of economic crisis, the central banks focussed heavily on buying gold to fill their reserves. The availability of increased reserves with the government allowed the governments to spend heavily on investment thereby leading the road to economic recovery. The requirement of increased labour led to the increase in employment opportunities and increase in the level of liquidity in the market. The increase liquidity was also controlled by the central banks by increasing the interest rates aimed at controlling inflation in the economy. Thus rise in the interest rates led to parking more funds in the financial institutions that offered higher returns as compared to gold. Instead of waiting for the appreciation of gold prices as a risk-averse nature, the investors started to take more risk in the financial markets for increasing their returns (Katz and Holmes, 2009, p.25)3. Adding to this was the increase in performance of the stock markets. The stocks markets recovered from the stages of recession and investment in securities were anticipated to produce higher returns as compared to investment in the gold markets. The opportunity cost of the gold markets no longer existed for which the demand of gold among the investors fell drastically. Corporate houses that banked on selling gold for so long also had to modify their strategies of investment. The fall in demand of gold in comparison to the previous demand led to comparative fall in the prices of gold. Thus the valuation of the investments in gold which were considered lucrative over the years was devalued during the time of economic recovery. The fall of the gold market saw liquidation of several hedge funds which banked heavily on gold. The reaction of the investors is mixed. Opportunists have spent heavily in buying physical gold bars, coins, jewelleries, etc in order to record future profits by buying at a discount (Dunkley, 2013, p.1)4. This has even depleted the inventory of gold bars in government treasuries like US. Price elasticity of demand for gold The price elasticity of gold is explained as the change in the quantity of demand due to change in price of gold. The unit change in the price of gold and subsequent unit change in demand in the quantity of gold is explained by the demand elasticity curve as given below. The increase in unit price represents unit increase in demand of gold and vice versa. The price elasticity of gold is represented by an elasticity of less then showing that price elasticity demand of gold is relatively inelastic. This means that the change in price reduction leads to a comparatively lesser change in the quantity demand of gold. Strategic decisions for investment in gold The strategic decision over investment in gold could be taken by considering the performance of the yellow metal over the last few years and the reason for undertaking the investment in gold. The annualized return over the last year is much less as compared to the last five years which shows that the prices of gold have plunged due to fluctuating economic conditions in the world. The return on gold investments was 4.2% in the last one year as compared to 18.6% in the last five years. The advantage of buying gold at reduced prices could be taken for storing jewelleries and gold ornaments required for special occasions in future (Warwick-ching, 1993, p.39)5. This will save valuable funds due to advantage taken from the low prices. The gold prices have no fundamentals but are associated to the ups and downs of the global economic scenario. The efficient strategies adopted by the policy makers have led to the rise in stock market performance for which the demand for gold has fallen. The investments which have already been done on gold and exchange traded funds have devalued putting the hedge funds into trouble. Looking at the past performance of the gold investment funds and the volatility in the economic conditions, it would wise to hold the investments in gold with an expectation of replenishment of gold prices. On the other hand, investors who wish to make quick bucks of money could decide to invest in gold by buying at lower prices with an opportunity to sell at higher prices in future (Shannon, 2010, p.47)6. However, taking all the economic factors into consideration, it is always wise to keep gold investments as a regular part of the portfolio. A loss in the stock markets or the commodity market could be offset the gain in the prices of gold and vice-versa. Moreover, gold is treated by the investors both in the form of a commodity and a currency. The presence of a large number of buyers like the financial institutions, jewellery houses, exchange-traded funds provide channels for trading of gold. Conclusion Although gold investment which was considered to be a secured investment for the last 30 years, it has lost its luster in present times due to recovering performance of the economy. It is to be noted that gold has a negative correlation with the other assets classes that could be chosen as an alternative to gold investments. Thus the investments in the gold market could help to diversify the risk of the overall portfolio of investment. References Dunkley, E. 2013. Investors are blowing hot and cold over the prospects for gold. [Online]. Available at: http://www.independent.co.uk/money/spend-save/investors-are-blowing-hot-and-cold-over-the-prospects-for-gold-8478331.html. [Accessed on 18 May, 2013]. Katz, J. and Holmes, F. 2009. The Goldwatcher: Demystifying Gold Investing. John Wiley & Sons; USA. McGuire, S. 2010. Hard Money: Taking Gold to a Higher Investment Level. John Wiley & Sons; USA. Northcott, A. 2010. The Complete Guide to Investing in Gold and Precious Metals: How to Earn High Rates of Return—Safely. Atlantic Publishing Company; Florida. Warwick-ching, T. 1993. International Gold Trade. Woodhead Publishing; UK. Shannon, J. 2010. The Gold Star Investment Strategy. AuthorHouse; USA. Read More