On the gravity equation of trade: a case of Germany

Abstract

Gravity models (equations) of trade belong among the most successful empirical tools in the modern economics since their fi rst economic applications in the yearly 1960s. They assume that bilateral trade is directly proportional to “economic sizes” (usually described in terms of GDP or income) of both trading partners and inversely proportional to their distance. The aim of this study was to examine Germany’s latest (2012) yearly aggregate exports to its major international partners by a gravity equation without and with selected trade frictions including a geographical adjacency (the so called border effect), an in fl uence of the same or different currency (Euro), and a location in the Schengen Area, the zone of a free movement of persons. Gravity models both without and with selected trade frictions fi tted the data well, while the model with frictions performed signi fi cantly better. The adjacency was found the most important single trade friction, the location in the Schengen Area appeared to be the least important friction (but it was still statistically signi fi cant). Other feasible trade frictions, such as border length, a location in Europe or democracy index were examined too, but their effect on the trade was rather negligible. A possible explanation of the border effect, based on information de fi ciency, is included in the study as well. Furthermore, it was observed that yearly Germany’s exports data are susceptible to large year-to-year fl uctuations especially for countries with low imports. Therefore, using averaged data over fi ve or ten years long periods might be more appropriate.