The paper "Implications on Econometric Analysis of Trade Flows" is a wonderful example of an assignment on macro and microeconomics. Carefully explain in what way the theoretically derived gravity model as in Anderson and van Wincoop "Gravity with gravitas" (2003), is superior to the empirically-based gravity model. What implications does this have for applied econometric analysis of trade flows? Introduction The use of gravity equations in inferring the effects of various trade flows among different institutional arrangements has been widespread. As Anderson and van Wincoop (2003) noted, this has been attributed to the fact that the gravity equation creates a relation of bilateral trade flows to the gross domestic product, the distance between countries as well as other factors that impose on trade barriers.
The empirical gravity equations have been purported by many to have a theoretical connection. Anderson and van Wincoop argue against this perception. Their argument is based on the fact that there has to be some form of multilateral resistance as the average trade barrier. The trade barrier between two bilateral partners decreases with the increase in resistance with the other partners in the region.
In this respect, the literature in empirical gravity does not incorporate multilateral resistance in its analysis. Therefore, the gravity model that has been theoretically derived by Anderson and van Wincoop (2003) is seen to be superior to the empirically-based gravity model. This paper justifies this superiority and further explains the implications that are accompanied by this argument on the applied econometric analysis of trade flows. The development of the gravity model was intended to explain the concept of international trade. The model was named the gravity model because it has an analogy with the law of gravitation as stated by Newton.
According to Deardoff (1998), the gravity equation best describes bilateral trade patterns by positively relating the trade between two countries to their incomes and by negatively relating them to the distance between the countries. This relation is done using a functional form that is similar to the gravitational law. In the equation, it is implied that trade between two countries is directly proportional to the GDPs of the countries and inversely proportional to the distance between the two countries.
Whenever the distance between the countries is great, the trade barrier between the two countries increases.
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