What is the relationship between the US dollar (USD) and the price of gold. We will be exploring some of the factors that cause changes in the USD. In the recent past the weakness in the USD has meant that the gold price has been increasing. We will be looking at the factors affecting the USD, and conversely why the price of gold had risen.
What are some of the factors affecting the Greenback?
Domestic Economy;
A countries domestic economy directly affects the exchange rate. The location of the US economy on the economic cycle (ie boom, bust, expansionary or contractionary) is one consideration influencing the the level of interest rates. i.e, a booming economy will induce central banks to increase interest rates to slow demand and reduce the possibility of inflation occurring. This has been noticed in Australia recently with the RBA (Reserve Bank of Australia) increasing interest rates to reduce inflationary pressures.
Due to the state of the domestic economy, the US has decreased interest rates to try and ensure there is liquidity in the economy. This interest rate differential has further devalued the greenback.
Another problem with the US economy is that the US owes net around $3 trillion to overseas nations. This has the effect on putting downward pressure on the USD. Furthermore, the US pays more interest on their debt to overseas nation than the interest they receive.
Foreign Currency Reserves; Countries like China, Russia, Japan hold vast amounts of reserves in foreign currencies and the USD is just one of the many they hold. It is estimated that countries (excluding the US) hold around $13 trillion in US currency. The major problem here is that if the US economy continues to show weakness and the USD continues to fall, then many nations who hold USD as foreign currency reserves might sell it and replace it with another nations currency, or even gold.
What affects the price of Gold?
The price of gold is primarily affected by two things. Geopolitical tensions and as an inflation hedge. When tensions in the Middle East are perceived to be at a very dangerous level, that is, they could boil over and cause a war in some countries or the supply of oil will be affected, then people will invest in gold. It is seen as a safe asset to hold in times of difficulty. Inflationary expectations also influence the price of gold. This was evident in the 1970s when inflation was very high and the price of gold increased as well. As mentioned above, central banks hold gold in their reserves, just in case there is geopolitical tensions or world inflationary pressures.
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