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How Do Gold Prices Affect the Economy?

By Motley Fool Staff – Updated Nov 25, 2016 at 4:06PM

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Many misunderstand the link between economic conditions and precious metals markets.

Many investors believe that changes in the price of gold can have an impact on the economy. There are a few industries in which gold prices have a direct effect. But it's more typical to see gold prices reflect economic conditions rather than causing them. Let's take a look at many ways in which gold prices tend to respond to changes in the economy.

Currency markets
In general, gold prices tend to reflect changes in the value of the U.S. dollar compared to other foreign currencies. When the dollar is strong, it means that even if gold prices stay flat in dollar terms, gold will be more expensive in foreign countries whose currencies have declined in value. That tends to cut demand and put pressure on gold prices, pushing them down in dollar terms. The opposite is true when the dollar weakens, because falling prices in foreign-currency terms make gold more attractive to purchase, thereby raising demand and pushing gold prices upward.

Economic strength
When the economy is strong, assets other than gold tend to perform well. Stocks in particular rise in value, driving investment demand away from precious metals and other commodities that don't generate any income. By contrast, when the economy weakens, demand for stocks and other financial assets slackens, and that drives more money toward what are perceived to be more stable investments such as cash and gold.

Interest rates
In a similar vein, interest rates also correlate to the price of gold. Low interest rates make it easy to choose gold as an alternative to bonds and other fixed-income investments, because they pay very little in income and have the risk of substantial decreases in value when rates rise. By contrast, high interest rates make bonds much more attractive compared to non-income-producing assets like gold, and the high borrowing cost for investors who have to take out loans to buy the yellow metal also make demand for gold dry up more quickly than usual.

Inflation threatens the value of financial assets like stocks and bonds, and it therefore makes gold look more attractive as a store of value. Because inflation often accompanies times of economic unrest, many investors look to gold as a safe haven investment for use in times of all sorts of distress, ranging from geopolitical conflict to systemic financial risk. When investors no longer trust currency, it's natural to turn to gold, and that helps push prices up.

Of course, the fact that these and other factors tend to move in different directions at the same time makes it clear just how difficult it can be to see the relationship between economic conditions and the gold market. Nevertheless, understanding some of the perceived fundamentals of how the gold market works can help you invest more effectively in the commodity.

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