Question

1. Think of the simple gravity model. Suppose there are two countries: the US and Mexico. Mexico’s GDP is 25 while the US’s GDP is 50. The distance between the US and Mexico is 2 while A equals 6.

1. Using the information in the question setup, what is the predicted amount of trade that should occur between the US and Mexico?
2. If the GDP of Mexico doubles, and the GDP of the US triples at the same time, what would the new predicted level of trade be according to the simple gravity model? Compare this to your answer in a).
3. Take your original answer in a), which tells you how much predicted trade should occur based on the gravity model. Now suppose the actual amount of trade that occurs between US and Mexico is 8000. Can you give at least one reason why this is different from what the gravity model predicts, if it is different from your answer in a)? If it is the same as your answer in a), explain why.

Answer 1

Given

Constant=A=6

GDP of US=Y_i =50

GDP of Mexico=Y_j=25

Distance between Mexico and country US =D_ij=2

a)

We know that T_ij is given by

T_ij = A x Y_i x Y_j /D_ij

where T_ij =Value of trade between Mexico and country US

Put values of given parameters

T_ij =6*50*25/2=3750

b)

GDP of US=Y_i =50*3=150

GDP of Mexico=Y_j=25*2=50

T_ij = A x Y_i x Y_j /D_ij

So, T_ij =6*150*50/2=22500

We find that as size of trading partners increases, expected trade between two countries increases.

c)

The predicted value of trade is quite different from the actual trade.Factors like trade agreements between two counties affect the volume of trade between two counties. Changes in political scenario affect the trade between two countries. Gravity model is not able to account changes due to such causes in short run.

a)