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This is a revised version of a paper presented at the Sixth Annual East Asian Seminar on Economics, Seoul, South Korea, June 15-17, 1995, and forthcoming in the conference volume. For comments we thank our discussants, professors Francis Lui and Chong-Hyum Nam, Takatoshi Ito, Anne Krueger, Donogh McDonald, and Mark Griffiths.
This approach, which we also adopt, takes economic growth within the Community as given. It therefore ignores any benefits to the rest of the world from greater prosperity within Europe generated by the regional integration.
This is less true of a comparison of developing and industrial countries, where exchange rates appear to consistent deviate from PPP values due to differences in productivity between traded and nontraded goods sectors (the Balassa-Samuelson effect).
Equation (2) does have an important disadvantage. When the gravity model is estimated in levels, it predicts the level of trade. When the rate of change specification is used, it is only possible to analyze whether trade is growing faster or slower than expected.
The countries were the United States, Japan, Germany, France, Italy, the United Kingdom, Canada, Australia, Austria, Belgium/Luxembourg, Denmark, Finland, Greece, Ireland, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, and Switzerland.
The U.S. GDP deflator rose by nearly 1 percent per annum faster than the export deflator over the period. This should be borne in mind in interpreting the constant terms.
In the alternative approach we experimented with various methods of calculating the real exchange rate. As they made little difference, we chose to use the PPP values. Distances between major cities, which were needed for the traditional gravity model, were obtained from USAF Aeronautical Chart for bilateral links in which one or both countries were outside of Europe, and from Rand McNally otherwise. Hence, within Europe distances were measured in terms of distances by road, those outside in terms of air miles.
Three-year averaging was a compromise between the desire to focus on secular rather than cyclical effects and the wish the distinguish as many separate periods as possible. We also experimented with four- and five-year averages, which in practice yielded very similar results.
For those, including ourselves, who regard this elasticity as implausibly large, this may be evidence of model misspecification. We return to this possibility below. Further evidence on the relationship between trade and growth in the industrial countries after World War II is provided by Irwin (1995).
Experimentation with alternative formulations of the distance variable, such as adding the square and cube of the logarithm of distance or including the absolute value of distance rather than its logarithm, produced some discernible changes in the estimated effect of distance. However, none of these alternative formulations significantly altered the coefficients on the other variables in the model.
Recall that the volume trade of trade is calculated using the GDP deflator for the United States.
Comprising West Germany, France, Italy, the Netherlands, Belgium, and Luxembourg.
Comprising, over this period, of the United Kingdom, Austria, Switzerland, Sweden, Norway, Denmark, and Finland. Iceland and Liechtenstein were also members, but were excluded due to their small size.
This value was calculated by an ancillary regression in which the EEC and EFTA dummy variables were included without time-specific dummies, which is equivalent to measuring the differential expansion in trade over the entire period. This is why the value is accompanied by an estimate of its statistical significance.
This calculation involves strong assumptions. All of the trend reduction in trade between the EEC and members of EFTA is assumed to reflect trade diversion by the EEC, for example. If some of the reduction in trade between the two blocs was caused by EFTA, then the estimated rate of increase of actual trade, and hence the share of trade creation, would be higher.
This calculation uses 1962-64 weights.
Trade between the United Kingdom, Denmark, and Ireland and other industrial countries and between the remaining members of EFTA and other industrial countries show no particular pattern, while there is a significant fall compared to expectations in the equivalent trade for the EEC.
As only industrial countries are considered, the Commonwealth consists of Canada, Australia, and New Zealand.
Trade between the original EEC countries and the remaining EFTA countries on the one hand and the rest of the world on the other show no pattern over and above that predicted by the model.
It also considers trade between the United Kingdom and Denmark and the remaining EFTA members; between the United Kingdom and the Commonwealth; and between all three countries and other industrial countries.
Again, however, there appears to be a marked decrease in the proportion of trade with developing countries.
As in the case of Greece, this may reflect general liberalization of the trade regime.
Complete results on all regressions are available from the authors on request.
This may be particularly important for a region such as Europe which includes a large number of countries which are geographically close to each other by the standards of the rest of the world, and hence where the distance variable may be particularly liable to misspecification.