Gravity Equations; Workhorse or Trojan Horse in Explaining Trade and FDI Patterns Across Time and Space?

Abstract

Gravity equations are a widely used tool in the international business literature to explain country-level trade and FDI flows. Against the background of its increased popularity and data availability, a range of commonly made econometric mistakes have recently been discussed in the literature, mostly pertaining to the (omitted) characteristics of countries or country pairs in gravity models. In this paper we complement this literature by focusing on the time-series aspects of gravity models, something that has become crucial with the increased use of panel data. Specifically, we concentrate on the possible non-stationarity of both the dependent variable (trade or FDI flows) and of one or more of the explanatory variables. In this paper we i) show that there is indeed a problem with the non-stationarity of variables commonly used in gravity equations; ii) show that not correcting for this yields overestimated results; and iii) propose an effective solution.

Keywords: Gravity equation, Trade, FDI, Time series