Even though gold isn’t used as money, it has a strong impact on the value of currencies in developed countries. The strength and value of currencies that are being traded on foreign exchanges has a strong correlation with the value of gold. This is due to the following features:
- Gold was used to back fiat currencies
For centuries, gold was used to support the currency systems in many nations. Through most of the 20th century gold was used as a global reserve currency.
When the gold standard was still in place, countries could only print their paper money with the gold it had in their reserves. Now that we no longer have the gold standard, countries do not have a limit on how much paper money they can print this adds to the volatility of their currencies.
- Gold is a good hedge against inflation
Gold cannot be diluted therefore it can retain it value better than fiat currencies. This is why a lot of investors buy gold in inflationary time.
To illustrate: In April 2011, investors drove the price of gold to $1,500 an ounce because of the declining value of the U.S dollar and other fiat currencies. The world market showed little confidence in fiat currencies and expectation of economic stability in the future were low. When something like this happens and you find yourself low on cash, you can sell the gold you have to gold dealers for a good price.
- The gold price has affects economies of nations that import and export it
Most countries’ currencies are tied to the value of imports and exports.
For example, a country that produces a lot of products made with gold but have to import most of it because they lack their own gold reserves will be susceptible to gold price increases.
Countries make up for their lack of gold reserves by strengthening their gold recycling industries. People who have gold whether it is fine bullion or used jewellery can sell their gold to gold dealers who in turn sell it to gold refineries. The gold is refined and sold to manufacturers and jewellery producers. Recycled gold offsets the amount of gold countries would need to export.
- The more gold is purchased the less the value of the currency that is used to buy it.
Central banks have to be careful when buying gold because it may affect the supply and demand of the local currency cause inflation. This is due to the fact that central banks rely on increasing the amount of printed money in order to buy more gold, this results in an excess in the supply of particular currencies.
- The price of gold is often used as a measure of local currencies
Although there is a correlation between the price of gold and the value of fiat currencies, the relationship isn’t always an inverse one as people would assume. It would therefore be a mistake to use the value of gold as a definite proxy for valuing any country’s fiat currency. For instance, if there is a high demand for gold in a particular industry that uses the yellow metal, it will cause the price of gold to go up as many gold dealers struggle to source the metal. This however will not say much about the local currency which could be high anyway. The conditions affecting the value of any currency relatively to the price of gold need to be analysed to determine their appropriateness of applying an inverse correlation.