July 17, 2020

Trade policy analysis with a gravity model

In this CPB Background Document we investigate the use of the standard structural gravity model for trade policy analysis at the CPB. The model is intended for long term analyses of trade policy changes and is based on a simple general equilibrium framework. The model is useful despite its simplicity, because it has a good empirical fit. We investigate it by applying the gravity model to both a US trade war scenario and different Brexit scenarios.

We compare the latter results to those reported in the literature and find that they are comparable. In addition, the model produces reasonably good out-of-sample forecasts of trade flow developments 3 to 6 years in the future. Hence, the gravity model can predict the impact of changes in trade policy on export flows well over the medium term. Given these results, we argue that the baseline gravity model would be a valuable addition to the CPB toolbox. However, CPB's analysis of the impact of trade policy on trade would benefit from supplementary tools, for example, to better model short-run trade flows. We conclude our report by discussing potential extensions to the gravity model.