gravity model

GRAVITY MODEL


Determinants of the trade
(In the context of USA and Srilanka)

Abstract
This paper tries to determine the determinants of the trade between Srilanka and USA in respect to 1985 to 2009 time period. Gravity model use to identify the trade determinants of USA and Srilanka. Particularly five variables checked whether they any relationship with trade, variables are; GDP (measured in PPP) of Srilanka, GDP (measured in PPP) of USA, Distance between Srilanka and USA, Population of Srilanka, Inflation rate of Srilanka (average consumer price index) and Unemployment rate of Srilanka.
Results gain by linear equation method suggest that all the variables are having relationship, but only the inflation of Srilanka having significant towards the trade of Srilanka and USA. GDP USA has negative relationship with trade between “USA and Srilanka”. When other variables are affects on trade positively.



Introduction
This research object to find the determinants of the trade between USA and Srilanka, According to the central bank annual report data (2009), USA is major trade partner of the Srilanka, USA is included in the top 10 trade partners with Srilanka (IMF, country database 2006), Srilanka exporting textile and garments and apparel, and agricultural goods like tea to USA and importing Consumer Goods, intermediate and investment goods.
The gravity model of trade has been widely used to estimate the impact of various policy issues, including preferential trade agreements, currency unions, and border effects. The model has a long tradition in social sciences where it has been used to model, for example, migration. In economics, the model has become very popular due to its success in explaining trade flows among countries.
After being introduced by Tinbergen (1962), the gravity model was considered to be a useful physical analogy with fortunate empirical validity. Subsequently, however, connections have been made to key elements of trade theory. The standard assumption of the Heckscher-Ohlin model that prices of traded goods are the same in each country has proved to be faulty due to the presence of what trade economists call “border effects.” Properly accounting for these border effects requires prices of traded goods to differ among the countries of the world.
Gravity models begin with Newton’s Law for the gravitational force (GFij) between two objects i and j. In equation form, this is expressed as:
GFij=(Mi.Mj)/Dij
(equation 01)






In this equation, the gravitational force is directly proportional to the masses of the objects (and ) and indirectly proportional to the distance between them (Dij).
Gravity models are estimated in terms of natural logarithms, denoted “ln”. In this form, what is multiplied in Equation 1 becomes added, and what is divided becomes subtracted, translating Equation 1 into a linear equation:

lnGFij=lnMi+lnMj-lnDij
(equation 2)

Mass in Equation 2 is associated with the gross domestic product (GDP) of the countries and distance. In this case, Equation 2 becomes
lnTRADEij=α+β1lnGDPi+β2lnGDPj+β3lnDij

Literature review
Research related to trade determinants using gravity model is available in the large amount, researches tried to find out the different trade determinant in the context of different country context.
Helpman and krugman (1985), conclude that countries GDP is always affects on the trade of that country in positive way, but leamer (1998)suggests that further research and clarification is in demand, because of the all the time results are not supporting to always GDP affect in positive manner. Regarding the GDP-related parameter estimates, the positive and significant coefficient estimates for overall economic size and the similarity of size index support the new trade theory MARIE STACK and ERIC PENTECOST

Most Researchers conclude that distance is affecting on the trade between two countries, commonly researches suggesting that when distance is low there is a high possibility of trade, but counter arguments for this is available in literatures, distance could bias estimation of the impact of distance over time because of the changing composition of trade (Jean-Franc¸ois Brun,et al), and technology reduced the effects of distance (celestino suarez burguet), This paradoxical result was initially investigated by Brun and others (1999) in a traditional gravity model framework. Earlier, Leamer and Levinsohn (1995,pp. 1387–88), reviewing the literature on international trade and distance, noted that ‘‘the effect of distance on trade patterns is not diminishing over time. Contrary to popular impression, the world is not getting dramatically smaller.’’ They conclude that ‘‘dispersion of economic mass is the answer, not a shrinking globe’’ for this result. In a recent examination of the paradox Coe and others (2002) review explanations in the literature.

A positive coefficient for total GDP is expected in line with the view that larger markets foster higher volumes of trade. The role of differential country size has been emphasised by Helpman and Krugman (1985)

According to MARIE STACK and ERIC PENTECOST research findings, The population coefficients of the exporting country are negative signed and remained rather constant, declining slightly in the 1990s. The population coefficients of the importing country are also negative signed but only until 1994. From 1995-1999 they are positive and significant in all years, with the time this values are changing this creates a demand for further researches.

In the context of Srilanka there is no researches are available or published to public uses, and contradictory ideas further increasing the need for demand.


Problem statement

Problem of this research is to find out which are the determinants of the trade between Srilanka and USA.

Objectives of the study
Find whether trade and GDP (measured in PPP) of Srilanka, GDP (measured in PPP) of USA, Distance between Srilanka and USA, Population of Srilanka, Inflation rate of Srilanka (average consumer price index) and Unemployment rate of Srilanka have any relationship between.
Find out what kind of relationship between the trade and variables is exists.

Methodology of the research
Research is prepared by using gravity model method, theoretical model have been changed as empirical model for research.

Theoretical model
GFij=(Mi.Mj)/Dij
(equation 01)
In this equation, the gravitational force is directly proportional to the masses of the objects (and ) and indirectly proportional to the distance between them (Dij).
Gravity models are estimated in terms of natural logarithms, denoted “ln”. In this form, what is multiplied in Equation 1 becomes added, and what is divided becomes subtracted, translating Equation 1 into a linear equation:

lnGFij=lnMi+lnMj-lnDij
(equation 2)

Mass in Equation 2 is associated with the gross domestic product (GDP) of the countries and distance. In this case, Equation 2 becomes
lnTRADEij=α+β1lnGDPi+β2lnGDPj+β3lnDij


Empirical model
With adding population, inflation and unemployment equation will be

"lnTRADEij=α+β1.lnGDPi+β2.lnGDPj+β3.lnDij+β4.lnPOPi+β5.lnINF+β6.lnUNEM"

"lnTRADEij" = total of imports and exports among country I and j, in the research Srilanka and USA
α= constant
"lnGDPi = " GDP (measured in PPP) of Srilanka
"lnGDPj = " GDP (measured in PPP) of USA
"lnDij = " Distance between Srilanka and USA
"lnPOPi = " Population of Srilanka
"lnINF = " Inflation rate of Srilanka (average consumer price index)
"lnUNEM = " Unemployment rate of Srilanka










Results of the research and conclusion

Coefficients of the research
Cons 9.556323
Population (SL) 0.0012204
Inflation (SL) 2.31
Unemployment (SL) 0.0000143
GDP (USA) (-0.0000144)
GDP (SL ) 0.0000297




Coefficient of the research is suggesting the following conclusions about the variables, population of the Srilanka is positively affecting to the trade, increasing in population will cause for increase in demand and production (by increasing the workforce), this will increase the trade in the direction of import and export.
Inflation of Srilanka is positively affecting on the trade, and it is the only value that affecting the trade significantly, inflation increment will be cause for reduction in the srilankan money value with compare to the USA dollars, which ultimately make the export prices reflect as low, by the inflation there will be a possibility to reflect USA import price as high for srilankan. This will increase the export and decrease the import. But Srilanka importing the industrial goods more from the USA which will make impossible to reduce the import even the prices are high. Situation will be enhancing the trade.
Unemployment of the Srilanka is positively affecting in the trade, direct causes for this cannot be predictable and it needed further researches to find out the real relationship between this two. This may be occur because of the incremental of the unemployment and trade values.
Gross domestic production of USA is negatively affecting the trade, this may be occur by recession period variations, when trade between USA and Srilanka slightly increased in the recession, the GDP amount of USA is sharply decreased in the recession period.
As expected Gross domestic production had positive relationship with the trade, possibly increment in the GDP will cause for export growth.

Results suggests that
R2 is 0.6995, which suggest that the overall model has ability to describe the variation of the trade, while it fail to describe the 31% of variation of the trade.
(in 99% confident level)p-values of variables)
Population (SL) 0.000
Inflation (SL) 0.898
Unemployment (SL) 0.10
GDP (USA) 0.123
GDP (SL ) 0.117

P-values of the variables suggest following
In 10% level population, unemployment GDP (USA), and GDP (SL) are significant (approximated percentages)  




References
marie stack and eric pentecost, a gravity model approach to estimating prospective trade gains in the eu accession and associated countries.
Helpman, E. and Krugman, P. R. (1985), Market Structure and Foreign Trade:
Increasing Returns, Imperfect Competition, and the International Economy,
Cambridge: MIT Press.
INMACULADA MARTINEZ-ZARZOSO, Gravity Model: An Application to Trade Between Regional Blocs.
Jean-Franc¸ois Brun, Ce´line Carre`re, Patrick Guillaumont, and Jaime de Melo, Has Distance Died? Evidence from a Panel Gravity Model, the non linear specification of linear model.
celestino suarez burguet, Has Distance Died? Evidence from a Panel Gravity Model