USA's GDP (at this time) is ~21 trillion dollards, and UK's is ~2.8 trillion dollars, then how come UK's currency is more than USA's. By that I mean, 1 GBP gets you more than 1 USD.

  • $\begingroup$ Generally, the exchange rate for currencies depends on the market forces(Supply and Demand) in the foreign exchange market. To my knowledge, trade is one of the major factors which affects the demand/supply for various currencies. I don't see how GDP would fit anywhere into this as it is only measuring domestically produced goods. $\endgroup$
    – Sahaj
    Jan 26 at 15:11

Because currency exchange rate does not depend only on the size of output. Using monetary model of exchange rates, which is reasonable first approximation for where the exchange rate between two countries should be, we get that exchange rate ($S$) is given by:

$$\ln S= \ln(m)- \ln(m_f) -(\ln(y)-\ln(y_f))+\lambda(i-i_f)$$

where $m$ is money supply at home and $m_f$ in foreign country, $y$ is the real output at home and $y_f$ in foreign country and $i$ is the interest rate at home and $i_f$ in foreign country.

According, to Statista the money supply (M2) in UK was about 2700 billion GBP, whereas in the US M2 was about 19 trillions (i.e. 19000 billions) of USD.

UK has slightly lower interest rate than US but the difference is very small.

As a matter of fact if you just naively apply the monetary model of exchange rates above (assuming away difference in interest rate to simplify calculations) you will find that GBP should be stronger than USD. This being said the model above won't give you precise exchange rate because in short run exchange rate can overshoot (e.g. as explained by Dornbusch overshooting model of exchange rate), or exchange rate might move in short run due to various other reasons (e.g. traders can scapegoat different fundamentals as predicted by the scapegoat theory of exchange rates (see Fratzscher et al 2015), or there might be carry trade etc.). Furthermore, what matters is not just the present value of the fundamentals but also how their expectations change, this is again not captured by the simple model presented above but more complex nuanced versions of it include expectations as well.

To sum up the GBP is stronger because there are more variables than just output that matter for exchange rate that are in favor of GBP and additionally even if fundamentals would suggest that USD should be stronger in short-run exchange rate can deviate from the rate that would be justified by fundamentals either because it overshoots or other reasons (discussing every possible reason for that would be beyond scope of SE answer, you can have look at an overview of literature in Copeland: Exchange Rates and International Finance textbook).


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