The gravity model
A typical tool in assessing bilateral trade’s causes and effects may be the gravity model. In a recently available paper (Baldwin and Taglioni 2011), we show that the gravity equation isn’t valid for trade flows where trade in parts and components is important.
The essential point is easy.
- The typical gravity equation comes from a consumer expenditure equation with the relative price eliminated utilizing a general equilibrium constraint (Anderson 1979, Bergstrand 1985, 1989, 1990).
- As such the typical formulation and empirical application (Anderson and van Wincoop 2003) is most beneficial adapted to explaining trade in consumer goods.
When consumer trade dominates, the GDP of the destination nation is an effective proxy for consumer demand; the GDP of the foundation nation is an effective proxy of its total supply.