GRAVITY WITH GRAVITAS

GRAVITY WITH GRAVITASABSTRACT
The gravity model has been widely used to infer substantial trade flow effects of institutions such as customs unions and exchange rate mechanisms. McCallum [1995] found that the US-Canada border led to trade between provinces that is a factor 22 (2,200%) times trade between states and provinces, a spectacular puzzle in light of the low formal barriers on this border. We show that the gravity model usually estimated does not correspond to the theory behind it. We solve the “border puzzle” by applying the theory seriously. We find that national borders reduce trade between the US and Canada by about 44%, while reducing trade among other industrialized countries by about 30%. McCallum’s spectacular headline number is the result of a combination of omitted variables bias and the small size of the Canadian economy. Within-Canada trade rises by a factor 6 due to the border. In contrast, within-US trade rises 25%.
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Introduction
The gravity model has been widely used to infer substantial trade flow effects of institutions such as customs unions, exchange rate mechanisms, ethnic ties, linguistic identity and international borders. The most celebrated inference is McCallum’s [1995] finding that the US-Canadian border led to 1988 trade between Canadian provinces that is a factor 22 (2,200%) times trade between US states and Canadian provinces. Obstfeld and Rogoff [2000] pose it as one of their six puzzles of open economy macro-economics. Helliwell and McCallum [1995] document its violation of economists’ prior beliefs. Grossman [1998] says it is an unexpected result, even more surprising than Trefler’s [1995] ‘mystery of the missing trade’. In consequence of this and because of the importance of trade costs for economic geography and macroeconomics, a rapidly growing literature is aimed at measuring and understanding trade border effects. So far none of the subsequent research has explained McCallum’s finding. We solve the border puzzle in this paper by applying the theory of the gravity equation seriously.