India is a major gold consuming country and the demand from India is acknowledged to be a significant factor in determining international gold prices. We submit that this paper is the first of its kind to develop a model for explaining and forecasting gold prices in India.
Gold is regarded as a good hedge both against inflation as well as the fall in value of other assets. Some factors that influence gold prices are inflation, exchange rate, bond prices, market performance, seasonality, income, oil prices, and business cycles. While these factors are expected to work in India as in other countries, there is an additional role of gold that may not be relevant elsewhere and has been hitherto ignored in literature. Indians buy gold not just for investment but also for personal reasons, to be used as a luxury good. If this reason to buy gold is significant, then higher affordability should lead to increased demand and therefore higher price for gold. We capture this wealth effect through the stock market index.
Our time series (April 1990 to August 2013) variables are non-stationary. We use a cointegrating framework, that is, vector error correction approach, to model and forecast the price of gold. The stock market index has a negative relationship with gold price contradicting the argument for gold being a luxury good but supporting the role of gold as a portfolio hedge. Oil price and exchange rate have negative relationships with gold price implying that gold is a good hedge against oil and the dollar as an investment. The consumer price index has a positive relationship with gold indicating that gold is a good inflation hedge.
We affirm robustness of the results of our exercise. The predictive capacity of our error correction model beats alternative specifications such as the random walk, using different sub-periods and forecasting horizons.
