GRAVITY WITH GRAVITAS: Macroeconomic analysts

While gravity equations used in empirical applications are known for their strong fit to the data, the estimated equations do not correspond to those derived theoretically. The theory, first developed by Anderson [1979], tells us that after controlling for size, trade between two regions is decreasing in their bilateral trade barrier relative to the average barrier of the two regions to trade with all their partners. Intuitively, the more resistant to trade with all others a region is, the more it is pushed to trade with a given bilateral partner. We define a theoretically appropriate average barrier below and call it multilateral resistance. McCallum did not include multilateral resistance variables in his analysis. Most of the subsequent literature does include a form of multilateral resistance in the form of an atheoretic remoteness variable related to distance from all bilateral partners. But the remoteness inde does not include national border barriers, even though these are the focus of this literature, and its functional form is at odds with the theory.
We will show that basing the empirics on the theoretically grounded gravity equation not only affects estimates of the impact of national borders on trade, but also provides a much more useful interpretation of the findings. there
The primary concern of policy makers and macroeconomic analysts is the impact of borders on international trade. McCallum’s regression model (and the subsequent literature following him) cannot validly be used to infer such border effects. In contrast, our theoretically grounded approach can be used to compute the impact of borders both on intranational trade (within a country) and international trade. Applying our approach to 1993 data, we find that borders reduce trade between the US and Canada by 44%, while reducing trade among other industrialized countries by 29%. While not negligible, we consider these to be plausibly moderate impacts of borders on international trade.