In the late 1970s, Britain seemed to have struck it rich. Having developed its North Sea oil-producing fields in earlier years, Britain suddenly found its real income higher as a result of a dramatic increase in world oil prices in 1979–1980. In the early 1980s, however, oil prices receded as the world economy slid into a deep recession and world oil demand faltered.

In the following chart, we show index numbers for the average real exchange rate of the pound against several foreign currencies. (Such average index numbers are called real effective exchange rates.) A rise in one of these numbers indicates a real appreciation of the pound, that is, an increase in Britain’s price level relative to the average price level abroad measured in pounds. A fall is a real depreciation.

Use the clues we have given about the British economy to explain the rise and fall of the pound’s real effective exchange rate between 1978 and 1984. Pay particular attention to the role of non-tradable
 

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Real Effective Exchange Rate of the Pound Sterling, 1976–1984 (1980 = 100) 1976 1977 66.5 1978 1979 1980 1981 1982 1983 1984 68.3 72.2 81.4 100.0 102.8 100.0 92.5 89.8 Real Effective Exchange Rate of the Pound Sterling, 1976–1984 (1980 = 100) 1976 1977 66.5 1978 1979 1980 1981 1982 1983 1984 68.3 72.2 81.4 100.0 102.8 100.0 92.5 89.8

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Step 1 The real effective exchange rate series for Britain shows an appreciation of the pound from 1... View the full answer