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Gold Investment as an Inflation Hedge

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Gold is hedge against inflation

There is a common notion that gold acts as an inflation hedge. Inflation is a phenomenon of rise in prices of goods and services of an economy over a certain period of time. In most of the countries, inflation is measured through Consumer Price Index (CPI) and is often considered as a consequence of rise in the supply of money that doesn't coincide with increase in the output of goods and services. For example, if we take the case of the U.S., with higher inflation, purchasing power of the dollar falls. This can lead to two cases:

• With fall in purchasing power of the dollar, investors will look for an alternative and gold being the precious metal, investors will go for it and this will push up prices. Thus dollar-based investors, concerned about possible inflationary consequences, try to hedge themselves from gold.

• On the other hand, fall in the dollar increases the purchasing power of other importing countries and make it easier for them to import gold which in turn push up prices.

• The precious metal is described as an inflation hedge because of the tendency of gold to hold its real terms value over long periods.

In the graph, gold prices continued with a rising trend over a long period of time and have surpassed the CPI during the referred time-period. During 2000-2012 period, the CPI has touched the highest level in 2010 and during that period gold also touched the level of $1081.05 per ounce, which is around 282% more than the price witnessed in 2000. With the raising trend in the consumer pricefactors are also needed to be considered at the same time. The situation of global economy, especially the U.S., serves as one of the detrimental factors. Apart from that, fluctuation in dollar prices and other dollar-denominated commodities coupled with regulation policies, demand-supply mechanism also play a vital parameter.

In recent history, a close association has been witnessed between the gold price and the U.S. dollar. The price of gold in January 1980 was $653 per ounce and on December 2012, it stood at $1,674 per ounce. Now the question is: whether during this period gold increased its value or the dollar lost its purchasing power. This rise has also been supported by uncertainty and weakness in major global economies. The supply of currency can be increased or decreased by the banks by issuing or printing new currencies, as and when required. However, the supply of gold is limited and it cannot be increased by central banks. Hence, gold is also considered as an ultimate alternative currency.

Gold also gives protection against currency depreciation. Currency depreciation is defined as a fall in the value of one currency with respect to one or more currencies. Here reduction is in terms of the purchasing power of that particular currency.

The value of all currencies depreciates over time, mainly due to inflation. However, it must be kept in mind that the factor of inflation is taken care by the country's banking system and it can be seen by the ever increasing supply of money.

Hence, saying that gold is a hedge against inflation is not totally correct. Inflation, gold and currency depreciation are closely related to each other. What is actually happening is currency depreciation followed by, and visible in, inflation. Gold rises with this increase in inflation.

Rather it can be said that gold is related to fear. If the fear factor of investors increases, demand of gold also increases, which results in rise in value of gold. This factor can be summarised by the words of Warren Buffett: "Gold is a way of going long on fear, and it has been a pretty good way of going long on fear from time to time. But you really have to hope people become more afraid in a year or two years than they are now. And if they become more afraid you make money, if they become less afraid you lose money, but gold itself doesn't produce anything."

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