Today, gold is sought after, not just for investment purposes and to make jewelry, but it is also used in the manufacturing of certain electronic and medical devices. Gold (as of August 2020) was over $2,000 per ounce and up considerably from levels under $100 seen 50 years ago. What factors drive the price of this precious metal higher over time?

Key Takeaways

  • Investors have long been enamored by gold and the price of the metal has increased substantially over the past 50 years.
  • Like most commodities supply and demand is incredibly important, but gold also retains additional value.
  • Government vaults and central banks comprise one important source of demand for the metal.
  • Investment demand, especially from large ETFs, is another factor underlying the price of gold.
  • Gold sometimes moves opposite to the U.S. dollar because the metal is dollar-denominated, making it a hedge to against inflation.
  • Supplies of gold are primarily driven by mining production, which has leveled off since 2016.

How Gold Prices Are Determined

Central Bank Reserves

Central banks hold paper currencies and gold in reserve. As the central banks diversify their monetary reserves—away from the paper currencies that they've accumulated and into gold—the price of gold typically rises. Many of the world's nations have reserves that are composed primarily of gold.

In fact, Bloomberg reports that global central banks are buying the most gold since the U.S. abandoned the gold standard in 1971. Russia has been the biggest buyer, followed by Turkey and Kazakhstan. In all, governments bought a total of 651 tonnes of gold in 2018, according to Bloomberg.

Value of the U.S. Dollar

The price of gold is generally inversely related to the value of the United States dollar because the metal is dollar-denominated. All else being equal, a stronger U.S. dollar tends to keep the price of gold lower and more controlled, while a weaker U.S. dollar is likely to drive the price of gold higher through increasing demand (because more gold can be purchased when the dollar is weaker).

As a result, gold is often seen as a hedge against inflation. Inflation is when prices rise, and by the same token prices rise as the value of the dollar falls. As inflation ratchets up, so too does the price of gold.

Worldwide Jewelry and Industrial Demand

In 2019, jewelry accounted for approximately half of gold demand, which totaled more than 4,400 tonnes, according to the World Gold Council. India, China, and the United States are large consumers of gold for jewelry in terms of volume. Another 7.5% of demand is attributed to technology and industrial uses for gold, where it is used in the manufacturing of medical devices like stents and precision electronics like GPS units. Therefore, gold prices can be affected by the basic theory of supply and demand; as demand for consumer goods such as jewelry and electronics increases, the cost of gold can rise.

Wealth Protection

During times of economic uncertainty, as seen during times of economic recession, more people turn to investing in gold because of its enduring value. Gold is often considered a "safe haven" for investors during turbulent times. When the expected or actual returns on bonds, equities, and real estate fall, the interest in gold investing can increase, driving up its price. Gold can be used as a hedge to protect against economic events like currency devaluation or inflation. In addition, gold is viewed as providing protection during periods of political instability as well.

Investment Demand

Gold also sees demand from exchange traded funds that hold the metal and issue shares that investors can buy and sell. SPDR Gold Trust (GLD) is the largest and held over 1,040 tonnes of gold in March 2020. In all, gold purchases from various investment vehicles in 2019 were 1,271.7 tonnes, according to the World Gold Council, representing over 29% of the total demand for gold.

While some ETFs represent ownership in the actual metal, others hold shares of mining companies rather than actual gold.

Gold Production

Major players in worldwide gold mining include China, South Africa, the United States, Australia, Russia, and Peru. The world's gold production affects the price of gold, another example of supply meeting demand. Gold mine production was roughly 3,260 tonnes in 2018, up from 2,500 in 2010.

However, despite the increase over a ten-year span, gold mining production has not changed significantly since 2016. One reason is that the "easy gold" has already been mined; miners now have to dig deeper to access quality gold reserves. The fact that gold is more challenging to access raises additional problems: miners are exposed to additional hazards, and the environmental impact is heightened. In short, it costs more to get less gold. These add to the costs of gold mine production, sometimes resulting in higher gold prices.

The Bottom Line

We have long been, and will likely continue to be, enamored by gold. Today, the demand for gold, the amount of gold in the central bank reserves, the value of the U.S. dollar, and the desire to hold gold as a hedge against inflation and currency devaluation, all help drive the price of the precious metal.