Academic journal article The Lahore Journal of Economics

An Analysis of the Relationship between Inflation and Gold Prices: Evidence from Pakistan

Academic journal article The Lahore Journal of Economics

An Analysis of the Relationship between Inflation and Gold Prices: Evidence from Pakistan

Article excerpt

Abstract

In this study, we formulate a new inflation equation to capture the potential effects of gold and stock prices on inflation in Pakistan. We aim to assess the inflation-hedging properties of gold compared to other assets such as real estate, stock exchange securities, and foreign currency holdings. Applying time-series econometric techniques (cointegration and vector error correction models) to data for 1960-2010, we find that gold is a potential determinant of inflation in Pakistan. On the other hand, it also provides a complete hedge against unexpected inflation. Real estate assets are more than a complete hedge against expected inflation, although stock exchange securities outperform gold and real estate as a hedge against unexpected inflation. Foreign currency proves to be an insignificant hedge against inflation. Given the dual nature of the relationship between gold and inflation, it is increasingly important for the government to monitor and regulate the gold market in Pakistan. Moreover, stock market investment should be encouraged by the government given that asset price inflation does not pose a critical problem for Pakistan as yet.

Keywords: Gold prices, inflation hedging, assets, time series econometrics technique, Pakistan.

JEL classification: E31, E37, E4.

(ProQuest: ... denotes formulae omitted.)

1. Introduction

Inflation is a worldwide macroeconomic problem owing to its adverse implications for economic expansion and income redistribution. Achieving a moderate level of inflation is, therefore, one of the main objectives of both developed and developing economies. In this context, a large body of theoretical literature has evolved over time identifying the determinants of inflation. There is also extensive research on this issue in Pakistan (see, for example, Rehman, 1994; Akhtar, 1990; Choudhri & Khan, 2002; Hyder & Shah, 2004; Khalid, 2005; Akbari, 2005; Kemal, 2006; Khan & Schimmelpfenning, 2006; Haque & Qayyum, 2006; Khan & Rashid, 2010). However, the dynamic and globally integrated nature of economic has altered previous relationships and led to the emergence of new phenomena affecting inflation. This means that we may require a revised inflation equation.

Gold prices have attracted considerable attention for their potential effect on inflation. Like other assets that are found to predict inflation behavior because their returns embed inflation expectations, gold prices can also serve as a leading indicator of inflation. This argument has been put forward by many researchers based on the failure of some financial assets to predict the behavior of inflation over a longer period of time (see, for instance, Stock & Watson, 1999; Cecchetti, Chu, & Steindel, 2000; Boivin & Ng, 2006; Banerjee & Marcellino, 2006).

There is very little literature on the inflation-predicting properties of gold and other financial assets in Pakistan. Gold prices have not been incorporated into inflation dynamics, nor has the relationship between inflation and asset prices been closely explored. This is because the idea is a relatively new one in the first case, while studies on the latter expect the two variables to be related in the opposite direction. However, with the heavy use of gold in Pakistan1 and the integration of its financial markets with international markets, it is reasonable to assume that both variables may contain some information about inflation.

Along with the evolution of the determinants of inflation, another key issue concerns hedging against inflation. Various assets are considered to provide a "safe haven" against inflation, e.g., stock exchange securities, real estate, and foreign currency. Gold is also expected to be an inflation- hedging asset, given its long-run association with inflation. However, the literature on the hedging properties of gold and assets in Pakistan is limited. Only one OLS-based study (Nishat & Mustafa, 2008) has been carried out, which rejects the significance of gold and stocks in providing a hedge against inflation. …

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