Controlling for Heterogeneity in Gravity Models of Trade

More documents

Recommendations

Info

PCSa model. Nonetheless, a likelihood ratio test rejects the null hypotheses that including thetrade bloc dummies in the PCSa model does not alter the results to a statistically significantextent. 14The results for the FEa model are also not dramatically different when the trade blocdummies are included. In fact, the null hypothesis that the inclusion of these variables has nostatistically significant effect on the results cannot be rejected. 15The dramatic change in the empirical results is in the comparison of the FEa and PCSamodels. The negative effects for all three trade blocs in the PCSa model are certainly contrary toexpectations. Not only are the coefficients on the European bloc and MERCOSUR dummiesstatistically different from zero, they are also very large. The results suggest that membership inthe European trade bloc decreases trade with another bloc member by roughly the same as wouldoccur if the distance between the countries doubled. The predicted decrease in trade due tomembership in MERCOSUR is three time this.Although these predictions have interesting implications regarding the future of the worldtrading system, they do not hold up when the estimation allows for heterogeneity. Using the FEamodel, all three trade blocs have positive effects on the volume of trade, although none arestatistically different from zero. However, this is likely due to the simplistic nature of thedummies, which do not account for trade diversion effects, rather than to the absence of realeffects (Cheng and Wall, 1999). For our present purposes though, the dummies we use are usefulto illustrate how the FEb model at least brings the results into the realm of believability.14 7KLVLVZLWKDFULWLFDOYDOXHRIDWWKHOHYHODQG 2 (3) = 79.38.15 7KLVLVZLWKDFULWLFDOYDOXHRIDWWKHOHYHODQG 2 (3) = 4.12.22
7. ConclusionsThe objective of this paper is to argue that heterogeneity needs to be allowed for whenusing the gravity model to estimate bilateral trade flows. Our empirical analysis indicates thatstandard methods for estimating gravity models of trade suffer from heterogeneity bias due toomitted or misspecified variables. To address the problem we adopt a two-way fixed-effectsmodel in which country-pair and period dummies are used to reflect the bilateral relationshipbetween trading partners. The fixed effects capture those factors such as physical distance, thelength of border (or contiguity), history, culture, language, etc., that are constant over the span ofthe data, and which are correlated with the volume of bilateral trade.We show that existing empirical models are special cases of our model, and that therestrictions necessary to obtain these special cases are not supported statistically. We concludethat the preferred specification of the gravity model takes into account the heterogeneity of thecountry pairs using country-pair dummies, and includes the populations of the two countries. Asthe gravity model has become the “workhorse” of empirical work on the effects of integration,we also check the importance of allowing for heterogeneity when doing this work. Our resultssuggest that the results when heterogeneity is allowed for can differ wildly from when it is not.23
Page 1 and 2: WORKING PAPER SERIESControlling for
Page 3 and 4: Controlling for Heterogeneity in Gr
Page 5 and 6: simply on the basis of goodness of
Page 8 and 9: independent variables are assumed t
Page 10: GDPs, their populations, and the di
Page 13 and 14: GDP should be associated with a 6.2
Page 15 and 16: that it may be different for each d
Page 17 and 18: cross-section results, the year dum
Page 19 and 20: country-pair effects from the FE mo
Page 21 and 22: and BEa results differ enough to re
Page 23: primary change over the period was
Page 27 and 28: ReferencesAitken, N. D., 1973, “T
Page 29 and 30: Table 1: Regression results for sin
Page 31 and 32: Table 3: Regression results with in

Controlling for Heterogeneity in Gravity Models of Trade

You also want an ePaper? Increase the reach of your titles

Delete template?

Save as template?