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AbstractThe gravity equation is the workhorse model of trade. Despite solid theoretical foundations and clear gains from theory‐consistent policy analysis, there are still gaps between gravity theory and empirics. This paper focuses on domestic trade flows, and I argue that there are significant benefits from adhering to theory by estimating gravity equations with domestic (in addition to international) trade flows. I review the related literature and synthesize 15 arguments for using domestic trade flows in gravity estimations. The analysis reveals the need for further theory contributions and new data developments, and points to opportunities for more policy applications.

Bilateral trade balances often play an important role inthe international trade policy debate. Disturbingly, several studies argue that the gravity model of trade fails when confronted with bilateral trade balances data, dubbing this "The Mystery of the Excess Trade Balances". Capitalizing on developments in the related literature, we solve the mystery and show that the gravity model explains bilateral trade balances well. We also uncover a new property of the structural multilateral resistances as asymmetric trade costs. This is exactly what solves the mystery. Our analysis suggests that, on average, there is little room for trade cost asymmetries due to 'unfair' policies to lead to bilateral trade imbalances. However, we also identify sectors (e.g., Mining and Services), where the modeling of the direct bilateral trade costs in the gravity model can be improved, including the possibility for 'unfair'/asymmetric policies to play a more significant role.

We propose a short-run model of the extensive margin of trade and deploy it to distinguish and quantify domestic and cross-border margins. Our empirical focus is on the domestic extensive margin of trade (domestic distribution of a product) and its importance for quantifying policy and globalization effects on the international extensive margin of trade. We build a dataset that combines data on the domestic extensive margin and the standard international extensive margin. It reveals significant and intuitive variation in the domestic extensive margin across countries and over time. We quantify the extensive margin effects of European Union (EU) integration, 2008-2018, and demonstrate that these effects cannot be identified without the domestic extensive margin. We find strong and highly heterogeneous effects, both across countries and directionally.

Bilateral trade balances often play an important role in the international trade policy debate. Academic economists understand that they are misleading indicators of competitiveness and of the gains from trade. However, they also recognize their political relevance, calling for accurate statistical measurement and for more scholarly work. Disturbingly, Davis and Weinstein (2002) argue that the canonical gravity model of trade fails when confronted with bilateral trade balances data, dubbing this "The Mystery of the Excess Trade Balances". Capitalizing on the latest developments in the theoretical and empirical gravity literature, we demonstrate that the workhorse international trade model actually performs well in explaining bilateral trade balances. Moreover, in our data, only 11 to 13% of the variance in bilateral balances is due to asymmetric bilateral trade costs, belying beliefs that bilateral imbalances are driven by 'unfair' manipulation of terms-of-trade. We also perform several general equilibrium experiments within the same structural gravity framework to show that free trade agreements tend to exacerbate bilateral imbalances and that macroeconomic rebalancing leads to adjustment with all trade partners.