gravity equation 2003 new
TRANSCRIPT
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The classical and new trade theory can
uccessfully explain the reasons for
ountries to join in world trade; however
hey cannot answer the question of theize o f the trade f lows.
the gravity model, which has been used
ntensively in analyzing patterns andperformances of international trade in
ecent years, can be applied to quant i fy
he trade f low s empir ical ly.
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The gravity model has long been
riticized for lack ing in theoret ical
oundat ion. Therefore in recent yearshere has been increasing interest in
providing the theoretical support for the
ravity model.
The name comes from the analogy to
ssac Newtons law of gravity, where the
orce of attraction between two bodies
epends on the bodies masses divided
by the squared distance.
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here are huge numbers of empirical applications of gravity
odel; it is not strange to have many variations of gravity
quation. However, the gravity model shares some commoneatures :-
GRAVITY MODEL IS APPLIED TO EXPLAINBILATERAL TRADE, THE DEPENDENTVARIABLE IS ALWAYS THE TRADE VARIABLE.
THE ECONOMIC MASS OF EXPORTING AND IMPORTINGCOUNTRY ARE MEASURED BY GDP OR GDP PER CAPITA,
GNP OR GNP PER CAPITA. THE IDEA BEHIND THIS ISCOUNTRIES WITH HIGHER INCOME TEND TO TRADE
MORE AND THOSE WITH LOWER INCOME TRADE LESS.
DISTANCE IS ANOTHER VARIABLE, ALSO APROXY FOR TRANSPORT COST, WHICH IS
USUALLY MEASURED AS THE STRAIGHT LINEDISTANCE BETWEEN THE COUNTRIES
GEOGRAPHIC CENTERS.
DUMMY VARIABLES ARE ALWAYS INCLUDED INORDER TO INVESTIGATE THE QUALITATIVE
VARIABLES.
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Tinbergenfirst applied this gravity model to
nalyze international trade flows in 1962 and
many others had followed to set up a series of
conometric model of bilateral trade flows. Theeneral gravity model applied in bilateral trade
as the following form :-
Tij =(A.Yi.Yj)/ Dij
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WHAT DOES THE THEORY SAY?
The simplest theoretical proposition of the
gravity model is that bilateral trade flowsbetween two nations tends to be directly
proportional to the product of their
respective GDPs and inversely proportional
to their distance measure. Hence, higher
the GDP ratio ,higher the trade volume andvice versa.
Distance between nations and trade flows
have a negative relationship. The Gravity
Theory essentially suggests that distance
tend to create barriers leading to highercosts.
Leamer and Levinsohn(1995) mention two
early studies and then claim
These and many subsequent studies have
found a distance elasticity of about -0.6.
Overman et al.(2003) state the elasticity of
trade volumes with respect to distance is
usually estimated to be in the interval -0.9 to
-1.5.
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According to the Gravity Theory other factors that might
affect bilateral trade flows are :
Cultural Distance-differential among nations.
Administrative Differences and Bureaucratic
hurdles. Unilaterally raised barriers could beminimized through bilateral agreements.
The Border Effect : This says that national
borders impedes trade. Empirical results about
rade between regions in Canada and in the USA
are remarkable since they show that intra-
national trade is dramatically higher than
nternational trade. Such results have been found
n other parts of the globe as well. Thus country
borders seem to matter a lot to retard trade.
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The empirical evidence for the gravity
equation in international trade is strong.Both the
role of distance and economic size are
remarkably stable over time, across
different countries,
and using various econometric methods.
Research by different economists over the
last few decades have revealed that there
is some
amount of dispersion in the estimated
distance coefficient, with a weighted
mean effect of 1.07 and 90% of the
estimates lying between 0.28 and 1.55.
Despite this dispersion, the distance
coefficient has been remarkably stable,
hovering around 1 over more than a
century of data .
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TRADE WITH INDIA
b2(dist) b1(GDP) a(const)
Trade(in mil. Eu) GDP(bil.$) Distance(k.m) -0.66231 3.747794 9990.348
A 1116 88 6532.76
RAIN 1179 32.4 2960
LIPINES 1253 417 4630.43
NTINA 1329 747 15944.49
OCCO 1434 171 8472.65
BAIJA 1438 98 3685.51 Correlation b/w trade and gdp 0.7757NMAR 1460 89 1768.23
RIA 1600 274.5 7699.53 Correlatiob b/w trade and dist -0.062
ANIA 1619 74 5888
AN 1623 38.7 4403.6
N 1683 57.8 3265.52
MBIA 1801 500 15989.86
STAN 1810 515 1454.48
AMAS 1890 11 14350.49
AINE 2359 335 5244.11E 2442 319 16710.51
L 2647 40.5 1013.31
A 3025 76 5021.79
N 3357 91 2393.59
ANKA 3530 126.2 1429.38
ADA 3591 1446 11481.96
EY 3686 1125 4636.36
CO 3966 1758 15111.31
T 4271 538 4929.08
G'DESH 4329 306 1223.69
NAM 4351 320 3193.86
EL 4844 248 4539.52
IA 5242 2486 4991.25
OLA 6645 126.21 7562.9
LAND 6964 646 2385.59
IL 8987 2330 14791.86
Z'LA 9579 402 15217.17
RICA 10120 579 8264.28
AYSIA 11030 492 3087.57
RALIA 12038 961 7822.21
12443 997 3646.15
AR 13155 189 2890.47
REA 13955 1622 4693
AIT 14694 166 3310.4
N 14955 4616 5965.98
GKONG 15388 364 3637.79'SIA 15564 1212 4490.02
16006 155 3751.47
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TRADE-GDP REGRESSION LINE
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TRADE-DISTANCE REGRESSION LINE
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Size of EuropeanNations and their tradewith the US
ource-U.S Department of Commerce, European Commission
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omparing Trade with E.Unations and neighboring countrie
ource-U.S Department of Commerce,
uropean Commission
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MORE ON
THE
GRAVITY
EQUATION
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A basic flaw of the Gravity Equation isthe analogy with the Newtonian Gravity
equation ,which states that Gravity
between two bodies can be very small
,but never zero.
We know ,however ,that it is absolutely
possible that two countries might not be
engaged in any kind of mutual trade.
The existence of observations for which
the dependent variable is zero creates a
problem for use of the log-linear form of
the gravity equation .
The Achilles Heel of the Gravity Theory
is its inability to explain the effect of
distance on trade. With the increasing
advancement of technology
,transportation has become extremelyconvenient ,and the role of distance on
trade should have diminished. But
empirical data has clearly shown even
now trade has a strong negative
correlation with distance.
GRAVITY DEFYING TRADE
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The analogy between trade and the physical force of
ravity, however, clashes with the
bservation that there is no set of parameters for
which the gravity equation will hold exactly for
n arbitrary set of observations. To account for
eviations from the theory, stochasticersions of the equation are used in empirical studies.
Tij = 0Y 1i Y 2j D3ij ij(1),
ives the Gravity Equation
where ij is an error term with E(ij |Yi, Yj, Dij) =, assumed to be statistically independent of the
egressors, leading to
E(Tij |Yi, Yj, Dij) = 0Y 1i Y 2j D3ij .
There is a long tradition in the trade literature of
og-linearizing (1) and estimating the parameters
f interest by least squares using the equation
n (Tij) = ln(0) + 1 ln (Yi) + 2 ln (Yj) + 3 ln
Dij) + ln(ij)..(2)
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The validity of these procedure depends on the
ssumption that ij , and therefore ln(ij), are
tatistically independent of the regressor. This is
ecause the expected value of the logarithm of a
andom variable depends both on its mean and
n the higher order moments of the distribution.
Hence, for example, if the variance of the error
erm ijin equation (1) depends onYi, Yj, or Dijhe expected value of ln(ij)
will also depend on the regressors, violating the
ondition for consistency of OLS.
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USES OF THE GRAVITY EQUATION
To test for dispersion relat ions hip : The gravi ty
equat ion helps us establ ish that s im i lar
cou ntr ies(in GDP terms) shou ld t rade more w ith
each other rather than w ith diss im i lar cou ntr ies.
Effect o f Trade Policy : It is a large research
pro gramme to test for the effects o f trade po l icy.In g ravi ty equations one somet imes inc lude
dummy var iables for m embership o f f ree trade
org anizations. General ly, such regression s
indicate that t rade pol icy is impo rtant for
internat ional trade. Countr ies w ith low trade
barr iers between them trade more than do othercountr ies.
Coun try Borders : Empir ical research about
t rade between regions in Canada and between
region s in Canada and in the USA show that
intra-nat ional trade is dramatical ly h igher than
internat ional trade. This is so also for US-
Canadian trade wh ich is one examp le of two
high ly integrated coun tr ies. Thus country bo rders
retard trade.
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CONCLUSION
The GRAVITY EQUATION of trade has achieved
what the Ricardian Model or the H-O model could
not ,i.e. ,to quantify trade flows. Even in the 21st
century , the equation has shown immense
empirical strength . Although the theoretical basis
of the model is lacking ,with the advancement of
research and economical studies ,we can only
hope that the Gravity Equation will become a more
mainstream theoretical model in Trade Theory .
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eference
Wikipedia.comDistancefromto.net
rade.ec.europa.eu.org
http://trade.ec.europa.eu/doclib/docs/2006/september/tradoc_113390.pdfhttp://trade.ec.europa.eu/doclib/docs/2006/september/tradoc_113390.pdf