Gravity with Gravitas: A Solution to the Border Puzzle

Abstract

The gravity model has been widely used to infer substantial trade flow effects of institutions such as customs unions and exchange rate mechanisms. McCallum [1995] found that the US-Canada border led to trade between provinces that is a factor 22 (2,200%) times trade between states and provinces, a spectacular puzzle in light of the low formal barriers on this border. We show that the gravity model usually estimated does not correspond to the theory behind it. We solve the 'border puzzle' by applying the theory seriously. We find that national borders reduce trade between the US and Canada by about 44%, while reducing trade among other industrialized countries by about 30%. McCallum's spectacular headline number is the result of a combination of omitted variables bias and the small size of the Canadian economy. Within-Canada trade rises by a factor 6 due to the border. In contrast, within-US trade rises 25%.