Why is Gold Such a Reliable Measure of Value?
An ounce of gold always seems to buy a good suit
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I sometimes hear people, especially those who think that we should return to a gold standard, say something like “an ounce of gold has always bought a good men’s suit.” This is true. And advocates of a return to the gold standard like to point out that it takes the same amount of gold today to buy a good men’s suit, but it takes far more dollars to buy a suit today than it did in the past. Why is that? Price theory can tell you.
Let’s start by thinking about the world under the gold standard. If the U.S. economy was on a gold standard, the dollar would be defined as a particular amount of gold. In today’s world, this might mean that the dollar is defined as 1/2000th of an ounce of gold. Given that definition, the dollar price of gold would effectively be fixed at $2000 per ounce.
Since gold is durable, we have to think about two distinct markets for gold. We need to think about the supply and demand of gold flows and we have to think about the supply and demand of the stock of gold. A flow variable is measured with respect to time. A stock variable is not. Thus, when thinking about the supply and demand for gold flows, the quantity of gold is the quantity supplied or quantity demanded per month or per year (or any other unit of time). The flow supply therefore captures the production of gold. The flow demand for gold captures the consumption of gold in terms of jewelry or industrial uses.
When thinking about the supply and demand for gold stocks, the quantity of gold is measured in ounces, independent of time. We can think of the stock supply and the stock demand as quantities of monetary gold (it could be broader than this, but let’s keep things simple).
Obviously, the relative price of gold is always the same in each market. In equilibrium, the quantity supplied is equal to the quantity demanded for both flows and stocks. However, what we are interested in are the characteristics of the long-run equilibrium and what ensures that we get there.
Let’s start by considering what happens when the demand for monetary gold changes. An increase in the demand for monetary gold will cause the relative price of gold to increase. However, this higher relative price creates an excess supply in the market for gold flows (higher prices cause movements along the supply and demand curves). What this means is that the quantity supplied per year of gold production will be higher than the quantity demanded. This excess supply of gold flows (new production beyond consumption demand) will find its way to the mint to be turned into coins. This increases the supply of monetary gold, which causes the relative price of gold to fall. The process continues until the relative price of gold returns to its original value.
Why is this important?
Well, what it tells us is that despite the fact that there might be fluctuations in the supply and demand for monetary gold, those fluctuations do not have an effect on the relative price of gold in the long run. The relative price of gold is just the money price of gold relative to all other goods and services. Recall that the money price of gold is fixed by the definition of the unit of account (in this case, the dollar = 1/2000th oz. of gold). Thus, if the relative price of gold is constant and the money price of gold is constant, the price level is also constant. The price of any particular good in terms of gold might have changed but, on average, the price of all other goods in terms of gold is constant over time.
Of course, even if there were no changes in the supply and demand for monetary gold, there still could be fluctuations in gold production or consumption over time that could have an effect on the relative price of gold. Since the question I posed at the beginning is entirely focused on the long run, we can confine our thinking on production and consumption to the long run.
A useful starting point for thinking about the long run would be as follows. For production, economists typically rely on a balanced growth assumption. In this case, it means that the production of gold would grow at the same rate as overall production. For consumption, the average income elasticity of demand across all goods must be 1. Thus, it might seem reasonable to impose this average on the flow demand for gold. This suggests that as income grows by 1 percent, the demand that good grows by 1 percent. If we maintain both of those assumptions, then production and consumption will grow at the same rate. In that case, the relative price of gold will remain constant.
Alternatively, we could think about the price theoretic underpinnings as follows. Optimal decision-making implies that the relative opportunity cost of producing gold is equal to the relative price of gold. At the same time, the relative price of gold will be equal to the marginal rate of substitution between gold and other goods. If the share of production dedicated to gold is constant, this implies that the relative opportunity cost of gold is unchanged. In the absence of some change in preferences, the relative price of gold would remain constant over time.
What this tells us is that when gold serves as money, there are additional fluctuations in the gold market and affect the relative price of gold. However, these fluctuations have no bearing on the long-run relative price because market forces correct for such changes. What matters for the long run is what is happening with the flow supply and flow demand, independent of whether or not gold serves as money.
Thus, even in the aftermath of the gold standard, the same general trend has continued. What matters is the relative productivity of the gold sector in comparison to other sectors. Over the long term, with balanced economic growth, the share of global production of gold remains constant. This implies that the price of other goods in terms of gold will tend to be relatively constant over time with only short-run variation caused by the relative scarcity of the good in comparison to gold.
And that is why you can always buy a good suit with an ounce of gold.