Exploring The Relationship Between Gold And Fiat Currencies
Gold is one of the most valuable commodities in the world, and is known to hold its value relatively well. Our ancestors held a strong value for gold, just as we do today—the precious metal dominated as a currency during the gold standard before it was replaced by fiat money.
Despite the shift to fiat currency, there is still a lot of misunderstanding about how the two influence each other or how currencies affect gold. Understanding the history of monetary value and the origins of the modern banking system might help provide a better understanding of the influences between gold and fiat currencies that we know today.
The gold standard
Commerce in the 19th century elevated gold’s status as the widely accepted method of exchanging value. However, carrying around a lot of gold for trade became dangerous and inefficient; thus, banks developed a system where people would keep gold in the bank. Instead, they would hold paper money to represent the value of the gold. This is the gold standard in which the value of paper money was attached to gold in the bank.
The gold standard means countries used gold as the reserve currency as opposed to the current system where the U.S. dollar is the global reserve currency. The advantage to the gold system was that banks had to hold a physical amount of gold, and they could only print as much money as the gold they held, which provides greater money stability since it is pegged to a finite amount of gold.
The disadvantage to banks is that they had a limited amount of gold bullion, which means they could not print as much money as they wanted; thus, they could not loan out more than the amount of gold in their reserve. Countries abandoned the gold standard in 1971, and the U.S. dollar replaced gold as the global reserve. This change ushered in the modern era of money, where central banks print money and maintain a balance of money supply in an economy. Unfortunately, this system is prone to inflation, but it also allowed banks to expand their influence exponentially.
How does gold affect fiat prices?
One of the best characteristics of gold is that it holds its value quite well. There has been a lot of debate as to whether fiat currencies influence the precious metal, but it seems to be the other way round, where gold continues to have a significant impact on the value of a currency. Gold prices’ relative stability is the main reason why many investors use it to hedge against inflation and economic conditions that have a negative impact on the value of a fiat currency. There are multiple ways in which gold influences fiat currency prices.
Hedging against inflation
Many investors buy gold at times when national inflation levels start escalating. Buying gold allows them to avoid the impact of inflation. Banks also deploy this tactic when inflation levels start affecting the local currency. They buy gold to hedge against losses as the local currency loses value, but in some instances, they may end up creating more inflation when they print more money to purchase gold.
Gold import and export
The value of a national currency is often affected by the importation and exportation of gold. The demand for the precious yellow metal makes it a hot commodity that is sold across the world. It also means that some of the countries that produce gold are able to generate a lot of wealth from the sale of gold. Some of the leading countries with the richest gold mines include Switzerland, the United States, the U.K., China, Russia, and South Africa, among others.
Countries with a healthy GDP tend to have a healthier currency because higher export levels relative to imports improve the economy, thus better currency value. Gold exporting countries, therefore, improve the value of their currency. The inverse is also true where countries with an unfavorable GDP tend to have a weaker currency; in this case, a country that imports a lot of gold will likely have a weaker currency.
Offsetting a trade deficit
Countries like China produce a lot of gold, and of course, they benefit from the sale of precious metal. However, there is an added benefit of an eased trade deficit, especially when gold prices go up, thus strengthening their currency. Inversely, countries that import a lot of gold take away from their currency value when gold prices increase.
Gold is commonly used to determine the value of a currency
The case of gold VS the U.S. dollar highlights an inverse relationship where the price of the precious metal tends to increase as the value of the dollar decreases. It could be argued that this relationship is largely supported by the large number of investors that purchase gold when the dollar is bearish to hedge against wealth corrosion. However, this may not always be the case. A country may have a strong currency even when gold prices increase, particularly in cases where the demand for gold is high.
There is a distinct relationship between gold prices and the value of fiat currency. In most cases, it is the precious metal that has a notable impact on fiat’s value, indicating that gold is deeply interwoven into the global economy. Its removal as the global reserve currency was not enough to terminate its economic influence.
Meanwhile, many other uses complement the valuable nature of the precious metal. For example, it is largely used to make expensive jewelry, and its electrical conductivity properties create some appeal in the electronic equipment industry. What stands out most about gold is that it maintains its value quite well and is not subject to inflation, unlike fiat currency. These properties ensure that gold will continue to play an important role in the economy, especially as a hedging tool against inflation.