# 360-2-1 - Chapter 2 Tools of Analysis for International...

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General Equilibrium (GE) Approach looks at all sectors/markets of the economy (labor, inputs, output, credit, foreign exchange, etc.). Advantage of GE : we can study/analyze effects of trade on all sectors, comprehensive approach. Disadvantage of GE : Complicated, requires simplifying assumptions. Assumption 1 : Economic agents (firms and consumers) act rationally. Firms maximize profits (or share price or shareholder wealth), consumers maximize “utility.” Without this assumption, behavior would be random and unpredictable and could not be modeled. Assumption 2 : Two country, two good world - America (A) and Britain (B) producing and consuming Soybeans (S) and Textiles (S). Goods are homogenous, tradable, and some of each is always consumed in both countries. Conclusions of a two-good, two-country world can usually be generalized to a many-country, many- good world. For convenience of geometric analysis (graphs), we limit to two variables. Assumption 3 : No money illusion, i.e. confusing nominal and real prices. Decisions should be based on real prices, real interest rates, real variables or relative prices, and not nominal prices (P S or P T ). Relative price ratio = P S / P T or \$10 / \$5 = 2 if 1 bushel of soybeans is \$10 and 1 yard of textiles is \$5. The relative price of soybeans in terms of textiles is 2, or 2x as expensive.
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