Check velocity of money before investing in gold

February 19, 2009

Commodity Online
MUMBAI: Even as gold prices baffle experts and analysts across the globe, there is a piece of advice from researchers that investors should also take into consideration the velocity of money indicator before they make decisions.

The indicator velocity of money moves inversely to money demand. Velocity of money rises when demand for money falls and people start spending again. When this indicator starts rising, then surely huge inflation is in the offing.

Gold is on a high in the recent past following the recession being faced by the developed world.

As the precious metal moves towards $1,000 per ounce from the current $970 level, experts advise to keep a tab on velocity of money before shifting investments to gold.

The safe heaven investment failed to go up as per expectations even as inflation soared and liquidity became scare.

Gold prices retraced from a high of $1,000 an ounce in March to $695 last year in the wake of the credit crisis.

But despite inflation falling across the globe due to various measures announced by world governments, the price of gold has shot up suddenly in past few weeks, startling analysts.

Like any other commodity, the value of money is a function of supply and demand. Thus, when the demand is higher than supply, the price of a commodity goes up and vice versa. Same is the case with money and its purchasing power or worth.

However, investors usually concentrate only on the supply. They believe an increase in money supply automatically leads to price inflation. If demand for money is equivalent to supply, then the value of a currency would remain unchanged. If demand for money rises faster than supply, then prices for other goods would fall.

This is what’s happening now. The central banks are increasing money supply by trillions of dollars. But there’s huge demand for money, too. It’s so strong that it’s offsetting the supply. This may not spur inflation and we will still be caught in deflation.

Money supply is guaranteed. Central banks control it. But demand for money is all about people’s confidence and sentiment, and both could change swiftly.

Demand for money is a little different than that for a regular commodity. That’s because money doesn’t waste as you consume it. Think about a $20 bill. It could go round and round in the economy hundreds of times but still be a $20 bill. So the way you measure demand for that $20 bill is by how long people hold on to it before they spend it.

In Zimbabwe, people spend their money as soon as they receive it. Every hour they hold cash, its value halves. So they turn it into food or gas or any other essential commodity. This makes demand for money in Zimbabwe extremely low.

In America, demand for money is extremely high. President Barack Obama has asked people to save money and reduce debt. However, the rising price of gold suggests that players are anticipating demand for money (dollar) to fall in near term.

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