3. Trade and the gravity model. Pair # Pair 1 Pair 2 Pair 3 Pair 4 GDP of i 350

Question

3. Trade and the gravity model. Pair # Pair 1 Pair 2 Pair 3 Pair 4 GDP of i 350 182 232 396 GDP of j 250 131 89 312 Distance 810 300 540 200 Actual Trade 10.2 17.8 8.6 48.7 a. The table above lists four hypothetical pairs of countries with their GDPs, actual trade values, measured as the sum of exports and imports, and physical distances between them Using a more general version of the gravity model of trade where the scaling constant A = 1.5, compute the predicted value of trade between the countries of each pair b. Compare the predicted value of trade and the actual one for each pair closely the actual values? In general, what could account for differences between the predicted and actual values? c. Lastly, try to think of a general situation where the gravity model will fail, i.e. it will severely over- or underestimate the trade between two countries . Do predicted values match

Explanation / Answer

Change in U.S. assets abroad -- includes our holdings of physical capital--e.g., factories in Mexico and Singapore--as well as paper assets--such as British stocks and bonds. Since we need foreign currency to pay for these assets, increase is -, because purchasing these assets uses up foreign exchange. Includes both private assets and U.S. government assets.
(2) Change in foreign assets in U.S. -- e.g., Japan's purchase of Rockefeller Center in 1980s was a big positive entry in the U.S. capital account. Again, includes both private assets and foreign government assets in U.S.

At present, the U.S. is running a big current account deficit, because of our big merchandise trade deficit; we're running a big surplus on the capital account. What does that mean? Well, we're importing a lot more than we export, so we need to exchange a lot of dollars for foreign currency in order to pay for these imports; foreigners are then stuck with all these dollars we've exchanged, and they invest them in the U.S.-- they buy land, buildings, companies, T-bills, stocks, etc. Even if they just sit on those dollars instead of investing them in the U.S., they've still got them, and their holdings of those dollars are entered into the capital account under "Change in foreign assets in U.S."

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