Untangling Real Gravity

Tinbergen Institute Discussion Paper 2017-121/VI

45 Pages Posted: 17 Jan 2018

See all articles by Franc Klaassen

Franc Klaassen

University of Amsterdam - Research Institute in Economics & Econometrics (RESAM); Tinbergen Institute

Rutger Teulings

University of Amsterdam - Research Institute in Economics & Econometrics (RESAM)

Date Written: December 29, 2017

Abstract

We derive a real gravity equation and gain several new insights that were hidden in the nominal specification used so far. Most importantly, the real effective exchange rate (REER) of the exporter and, via the importer's terms of trade, also the importer's REER matter, and we can identify the elasticity of substitution. We estimate real gravity for 18 OECD countries. Therefore, we extend the untangling normalization method from an “it” to an “ijt” panel data model and use it to exploit all variables proposed by theory, despite a broad set of fixed effects (FE). We find that both REERs are important and estimate an elasticity of substitution of 1.5. If we assume homogeneous parameters, as is common, the remaining unexplained exporter-time and importer-time deviations are still substantial, relaxing this assumption improves this. We now explain 64 and 70% of the exporter-time and importer-time deviations, respectively, and thus the majority of the exporter and importer multilateral resistances. Untangling normalization helps to get a better view of what is still unexplained by theory.

Keywords: real gravity equation, exchange rate, multilateral trade resistance, untangling normalization

JEL Classification: C18, F10, F14

Suggested Citation

Klaassen, Franc and Teulings, Rutger, Untangling Real Gravity (December 29, 2017). Tinbergen Institute Discussion Paper 2017-121/VI, Available at SSRN: https://ssrn.com/abstract=3100119 or http://dx.doi.org/10.2139/ssrn.3100119

Franc Klaassen (Contact Author)

University of Amsterdam - Research Institute in Economics & Econometrics (RESAM) ( email )

Roetersstraat 11
Amsterdam
Netherlands
+31 20 525 4191 (Phone)
+31 20 525 4254 (Fax)

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Rutger Teulings

University of Amsterdam - Research Institute in Economics & Econometrics (RESAM) ( email )

Roetersstraat 11
Amsterdam
Netherlands

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