Question

1) The gravity model describes an empirical relationship between value of trade, size of the economies, and distance between the economies.

a. Write out the generic form of the gravity model and briefly discuss how you would use this model to verify whether its implications are supported by data or not. (10 pts)

b. Suppose the gravity model generally holds for the U.S. and its trading partners. However, a restrictive trade policy limits the trade value without changing the sizes of the economies and the distance. For example, the USMCA mandates at least 75% of an automobile’s value must come from domestic origin. How is this policy reflected in the gravity model? How would you justify such policy using the gravity model?

Answer 1

A)

The gravity model reveals the empirical relationship between size of the economies, value of trade and distance between the economies. The model explains the role of distance between countries in determining trade. As economic distance increases , the trade cost also increases. The distance between countries includes several variables like political and cultural differences among countries. The international trade data all over the world favouring the gravity model. The size of economy influences bilateral trade. A country with better trading standards and growth rate can have comparitive advantage in trade.

B)

A restrictive trade policy in a country limits the value of trade, even the sizes of the economies and the economic distance are not vary.
If USMCA mandates a limit such that at least 75% of values of automobile’s should be from domestic production.
The restrictive trade policies reduces the value of trade. The limits and restrictive policies are type of protectionism that enhance domestic production. The gravity model analyses the role of agreements and international trade treatises in raising trade value and restrictive trade policies limits the value of trade.