What Drives The Price Of Gold?

The ancient Egyptians performed the first smelting of gold circa 3,600 BC. A thousand years later, gold jewelry appeared as the goldsmiths of ancient Mesopotamia crafted a burial headdress made of lapis, carnelian beads and leaf-shaped gold pendants. Since these early days, mankind has been fascinated by gold, and the desire to own it has led to great gold rushes and to wars: King Ferdinand of Spain declared in 1511, "Get gold, humanely if you can, but at all hazards, get gold!"

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Today, gold is sought after not only for investment purposes and a strong jewelry market, but it is also used in the manufacturing of certain electronic and medical devices. Gold (as of March, 2011) was around $1,420 per ounce and making record highs. What factors drive the price of this precious metal?

Central Bank Reserves
Central banks hold paper currencies and gold in reserve. The World Gold Council has stated that central banks have recently begun buying more gold than they are selling, the first time this has happened in decades. As the central banks diversify their monetary reserves - away from the paper currencies they've accumulated and into gold - the price of gold rises. Many of the world's nations have reserves that are composed primarily of gold, including the United States, Germany, Italy, France, Portugal, Greece and the Euro area. (Learn more in What was the Gold Reserve Act?)

Value of the U.S. Dollar
The price of gold is generally inversely related to the value of the United States dollar: a stronger U.S. dollar tends to keep the price of gold lower and more controlled; a weaker U.S. dollar is likely to drive the price of gold higher. This is because people have a tendency to invest and trade in dollars when the dollar is strong. During times of economic uncertainty and when the dollar is weak, however, people prefer to invest in gold, through vehicles such as gold funds or coins.

Worldwide Jewelry and Industrial Demand
In 2010, jewelry accounted for approximately 54% percent of gold demand, which totaled 3,812 tonnes, according to the World Gold Council and The London Bullion Market Association. India, China and the United States are the largest consumers of gold for jewelry in terms of volume. Consumer demand in China, for example, for the first two months of 2011 reached 200 tonnes - a huge increase over the previous year, which took 10 months to reach 209 tonnes. Another 12% of demand is attributed to medical and industrial uses for gold, where it is used in the manufacturing of medical devices like stents and precision electronics like GPS units. Gold prices can be affected by the basic theory of supply and demand: as demand for consumer goods such as jewelry and electronics increase, the cost of gold can rise.

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Wealth Protection
During times of economic uncertainty, as seen during the recession of the late 2000s, more people turn to investing in gold because of its enduring value. Gold is often considered a "safe haven" for investors during uncertain times. When the expected or actual returns on bonds, equities and real estate fall, the interest in gold investing increases, driving up its price. Gold can be used as a hedge against currency devaluation, inflation or deflation. In addition, gold is viewed as providing protection from political instability, as evidenced by the recent unrest in the Middle East and North Africa (MENA), which may be partly responsible for gold's recent rally to new highs. (Learn more in Tips For Recession-Proofing Your Portfolio.)

Gold Production
Major players in worldwide gold mining include China, South Africa, the United States, Australia, the Russian Federation and Peru. The world's gold production affects the price of gold, another example of supply and demand. Gold mine production increased by about three percent in 2010 to about 2,652 tonnes, according to GFMS as several new large-scale mines began operations. Despite this small increase, however, gold mine production has been in a decline since the early 2000s. One factor is that all 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: the 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, resulting in rising gold prices.

The Bottom Line
We have long been, and will likely continue to be, enamored by gold. The recent recession has stirred a modern day gold rush. Discovery Channel's Gold Rush: Alaska, a reality show about a team of inexperienced miners hoping to strike it rich in Alaska's backcountry, brought in more than 4 million Friday-night viewers. The Gold Prospectors Association of America, a group that caters to recreational miners, saw membership nearly double in 2008 as the gold bug spreads. The demand for gold, the amount of gold in the central banks' 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 gold, one of the world's precious metals.