GOLD PRICES AND POLITICAL TENSION (RISK, INSTABILITY)

Research literature and popular press articles are reviewed concerning the issue of whether or not the market price of gold is sensitive to political crisis. Although there is a largely held belief that political crisis affects gold prices it is shown that political turmoil in general has no systematic effect on gold prices. However a special set of political development in Middle Eastern countries has a strong impact on gold prices.;A second approach is to estimate a gold price equation jointly with an oil price equation using a time domain dynamic factor analysis. This technique creates an unobservable political crisis variable which is used by the technique as a proxy for political crisis in the Middle East. The estimation results indicate that the unobservable political crisis variable has a significant positive impact on both the gold and the oil price and that this unobservable political crisis variable is significantly linked to armed attacks and riots in the Middle East.;A simulation exercise is used to test the validity of the model and its response to political tensions. The model simulates price developments over the entire sample period extremely well.;An instrumental variable technique is used to test the hypothesis that political crisis in the Middle East has an impact on gold prices. The results indicate that political crisis as measured by armed attacks and riots in the Middle East has a significant positive impact on gold prices while political crisis measured in terms of armed attacks and riots in non Middle East countries has no impact.