One would assume that the strongest economies would have the strongest global currencies; however, that is not always the case. It turns out that long-term movements in currency prices are more important than exchange rates, which is why the British pound is worth more than the U.S. dollar. But this does not change the fact that the U.S. dollar is the world's most traded currency and the world's reserve currency.
- Despite the U.K.'s smaller economy, one British pound has historically been worth more than one U.S. dollar.
- The price of one currency compared to another is not necessarily an indication of wealth, power, or strength.
- A currency that increases in value against another over many years is generally considered to be a stronger currency.
- Even though the pound is ostensibly worth more than the dollar, the U.S. dollar is still the world's most traded currency and the world's reserve currency.
When one country's currency is worth more than that of another, it does not necessarily indicate a stronger economy. For example, the Japanese yen (JPY) is regarded as one of the world's strongest currencies, yet a Japanese yen is worth only about one U.S. cent. Historically, one British pound has usually been worth more than one U.S. dollar, even though the U.K. has a much smaller economy.
The fact is that looking at a currency's worth relative to that of another currency at a static point in time is meaningless. The best way to judge a currency's strength is by observing its value in relation to other currencies over many years. Supply, demand, inflation, and other economic factors will cause changes to a currency's relative price. It is these changes that ultimately determine the relative strength of a currency.
Quoting Conventions and Relative Values
Part of the appearance of strength in the British pound (GBP) is the way the currency is quoted relative to the U.S. dollar (USD)—e.g., 1.2500 GBP/USD, or $1.25 equals a pound. This quoting convention has been the way the British pound has traditionally been quoted against the USD and other major currencies. Some other other currencies are also quoted in this manner, such as EUR/USD—the single European currency, or euro (EUR), against the USD, where a EUR/USD exchange rate of 1.2000 means that one euro is worth 1.2000 U.S. dollars.
The quoting convention for the pound stems from the days of British Empire, when the U.K. economy was actually bigger than the U.S. economy (late 1900s to WWI). Quoting conventions are hard to change, and that has been the case even though the USD and its economy have long eclipsed the GBP in both value and size.
Purchasing Power Parity (PPP)
The other element to take into account is purchasing power parity, or PPP, where a currency's worth is based on how much a basket of goods is valued in the two currencies. For example, using a rate of GBP/USD 1.2500, a basket of goods worth 100 pounds should cost 125 U.S. dollars. Of course, PPP is a theoretical construct to provide some kind of anchor against exchange rate movements, meaning that the exchange rate should not deviate significantly from its PPP level.
The degree to which a currency deviates from its PPP is one popular measure of the relative strength or weakness against another currency. The difference between the market currency rate and PPP is usually attributed to speculative forces, which in turn are taking their cues from interest rate differentials and economic performance over time.
The Decline of the British Pound
Although one British pound was worth a little more than one U.S. dollar in 2022, it used to be worth a lot more. Britain had a global empire in 1900, and the British pound was worth almost five times as much as the U.S. dollar. World War I, World War II, and the breakup of the British Empire took a heavy toll on the pound, leaving the U.S. dollar as the primary currency of exchange.
For instance, nearly all commodities (oil, grains, and metals) are priced in U.S. dollars. The USD also asserted itself as the primary reserve currency, accounting for about 60% of currency reserves, or more, held by other countries. In times of market upheaval (e.g., stocks are plunging due to poor economic news or fears emerge that geopolitical matters may disrupt the global economy), the USD is considered the ultimate safe-haven currency. The U.S. overtook the British empire as the largest economy in the 1890s, and the dollar became the world's reserve currency in the 1920s, shortly after World War I.
During much of the 20th century, the British pound depreciated against the U.S. dollar. This decline made the pound a weak currency, even though it was worth more than the dollar. By the 1980s, the value of the British pound hit a bottom. Between the 1980s and 2021, the pound stabilized against the dollar and usually traded for between one and two U.S. dollars.
Why Is the Pound Worth More Than the Dollar?
The pound is higher than the dollar because long-term price movements play a role in the face value of a currency. At one point, the British pound was five times higher than the dollar, but over the 20th century—due to the two World Wars, the loss of the British Empire, and other negative factors—the British pound lost value and significantly depreciated, to a point where it now typically sits between one and two dollars.
The value of the GBP can fluctuate significantly against the USD. For example, since the start of 2022 to October 2022, the pound and the dollar strengthened, bringing GBP/USD from around 1.3700 to 1.0500, a change of nearly 25%! This episode shows how currencies can move significantly based on a country's economic outlook (GBP bad/USD good) and interest rate differentials (USD good/GBP bad), among other variables.
Is the British Pound Stronger Than the USD?
It depends how you look at it. The typical currency quotation of GBP/USD gives the appearance that the pound is worth more than the U.S. dollar, but other measures such as PPP suggest that the USD is worth more than the British pound. The exchange rate fluctuates over time, where sometimes the pound is relatively stronger than the USD, and vice versa.
For example, say the price of a pint of beer is GBP 4.00. If the exchange rate is 1.2500, that means the pint costs $5.00 in dollars. If, on the other hand, the exchange rate is 1.1500, (meaning the GBP has weakened against the USD), that same GBP 4.00 pint costs only about $4.60. If the pound strengthens against the U.S. dollar to, say, 1.5000, that same pint now costs $6.00. This demonstrates that currency values fluctuate and that exchange rates are only a relative measure of value versus another currency.
What Is a Good Exchange Rate for Pounds to Dollars?
Again, this is a relative question. If the GBP/USD rate is high, say, 1.7500, meaning the pound is relatively stronger than the USD, your USD will buy fewer pounds (it would take $1.75 to buy one British pound). If on the other hand, the USD has strengthened, the GBP has weakened, and the GBP/USD rate is 1.2500, it would take only $1.25 to buy one pound.
As to the question of what is a good exchange rate for the GBP against the USD, it depends on what side of the transaction you sit. For example, if you're an American tourist visiting the U.K., you would prefer a relatively weak pound, meaning it takes fewer U.S. dollars to buy a pound. At the same time, if you're a British tourist visiting the U.S., you would prefer a relatively strong pound, where one pound gives you more dollars.
What Makes a Strong Currency?
A currency is considered relatively strong if its value compared to another currency rises. A currency is considered relatively weak if its value falls relative to other currencies. So what makes a currency rise or fall in value against other currencies? Many factors come into play, but the most important variable would be interest rate differentials. This is where the currency with the higher relative interest rates strengthens against the currency with lower relative interest rates. Numerous other factors come into play: trade balances, economic outlooks, interest rate expectations, and overall market sentiment.
The strongest currencies are considered to be so-called safe-haven currencies. In that realm, the Swiss franc (CHF), the JPY, and chief among them the USD are considered safe havens in times of turmoil. The U.S. dollar is clearly the standout safe-haven currency when times get rough, owing to its massive liquidity, its prevalence as a reserve currency, and the credibility of the U.S. Treasury and the Federal Reserve.
The JPY is also considered a safe-haven currency due to perpetual trade surpluses and the fact that nearly 50% of Japanese debt is held by the Bank of Japan, with another 35% held onshore by Japanese institutions and individuals. The CHF gets its safe-haven status primarily because one-third of global assets are held in Switzerland. So when markets desire to bring money home, which is the natural inclination during times of market turmoil, the three main destinations are the USD, the JPY, and the CHF.
The Bottom Line
Although the British pound is worth more than the U.S. dollar on a nominal basis, the dollar is still a stronger currency due to its status as the world's reserve currency and its greater volume of trading in the forex markets. The U.S. economy is a larger and stronger economy than that of the U.K., and so a greater value is placed on its currency, even if the exchange rate means that one dollar buys less than one pound sterling.
Not too much should be inferred from the GBP/USD exchange rate as to which currency is stronger or weaker. Instead, investors need to look back over the historical exchange rate levels to gauge which currency is relatively stronger or weaker at that moment in time. As of this writing, the pound is extremely weak against the USD, around 1.13. Given the macro-economic outlook for both the U.S. and the U.K., the USD could strengthen further, potentially driving the pound below parity of 1:1. Then that GBP 4.00 pint will cost only $4.00!