In this chapter, we present the building blocks for trade policy analysis using a computable general equilibrium (CGE) model. We begin by reviewing the trade data in the Social Accounting Matrix (SAM). Next, we introduce two concepts, the real exchange rate and terms of trade, and explain how they are represented in standard CGE models. We then focus on trade theory as we simulate and interpret the results of two types of shocks: a change in factor endowments that change comparative advantage, and a change in world prices that changes industry structure, trade, and factor returns. We study an example of “Dutch Disease,” a problem that illustrates the links between a change in world prices, the real exchange rate, and industry structure. We conclude with an explanation of the role of trade margin costs in international trade.

This chapter provides an introduction to exchange rates, including the nominal and real exchange rate. It describes and assesses the purchasing power parity model of exchange rate determination. It considers the role of hedging and foreign exchange derivatives. Appendices look at price levels and the PPP model and develop the monetary approach to exchange rate determination.