Instrumental-Variable Estimation of Gravity Equations

We present an instrumental-variable approach to estimate gravity equations. Our procedure accommodates the potential endogeneity of policy variables and is fully theory-consistent. It is based on the model in levels and accounts for multilateral resistance terms by means of importer and export fixed effects. The implementation is limited-information in nature, and so is silent on the form of the mechanism that drives the actual policy decisions. The procedure spawns specification tests for the validity of the instruments used as well as a test for exogeneity. We estimate gravity equations from five cross-sections of bilateral-trade data where the policy decision of interest is the engagement in a free trade agreement. We rely on the interaction of the countries in the pair with third-party trading partners to construct a credible instrumental variable based on the substantial transitivity in the formation of trade agreements that is observed in the data. This instrument is strongly correlated with the policy variable. Our point estimate of the average impact of a free trade agreement increases over the sampling period, starting at 61% and clocking o_ at a 117% increase in bilateral trade volume. Not correcting for endogeneity yields stable estimates of around 25%