Gravity in Transition

Abstract

We propose a reduced-form transitional gravity model and an accompanying flexible reduced-form estimation approach. The Lucas–Prescott adjustment model is extended to allow for lag-interval-varying depreciation-cum-adjustment-cost of bilateral trade capacities. The resulting lag-interval-varying trade elasticities vary from 0.4 in the short run to 4.8 in the long run. Long-run equilibrium is reached in about 14–15 years. The model rationalizes trade elasticities that are less than one and offers a potential solution to the ‘international elasticity puzzle’–the discrepancy between trade elasticities from the trade and macro literatures. Theories of dynamic adjustment in trade costs are supported, and phasing-in effects of FTAs are explained.