For more than forty years, the gravity equation has been a workhorse for cross-country empirical analyses of international trade flows and, in particular, the effects of free trade agreements (FTAs) on trade flows. However, the gravity equation is subject to the same econometric critique as earlier cross-industry studies of U.S. tariff and nontariff barriers and U.S. multilateral imports: Trade policy is not an exogenous variable. The authors address econometrically the endogeneity of FTAs using instrumental-variable (IV) techniques, control-function (CF) techniques, and panel-data techniques; IV and CF approaches do not adjust for endogeneity well, but a panel-data approach does. Accounting econometrically for the FTA variable’s endogeneity yields striking empirical results: The effect of FTAs on trade flows is quintupled.
JEL classification: F10, F13
Key words: international trade, free trade agreements, gravity equation
The authors are grateful to Jonathan Eaton, Rob Feenstra, Scott Kastner, Mika Saito, Curtis Simon, Jeff Wooldridge, Eduardo Zambrano, and two anonymous referees for excellent comments on earlier drafts and to Doru Cojuc, Katie Martin, Kushlani Rajapakse, Duncan Stewart, and Li Zhang for excellent research assistance. The authors are grateful to the National Science Foundation for financial support. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.
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