Trade costs, trade balances and current accounts: An application of gravity to multilateral trade

In this paper we test the well-known hypothesis of Obstfeld and Rogoff (NBER Macroeconomics Annual 7777:339-390, 2000) that trade costs are the key to explaining the so-called Feldstein-Horioka puzzle. Our approach has a number of novel features. First, we focus on the interrelationship between trade costs, the trade account and the Feldstein-Horioka puzzle. Second, we use the gravity model to estimate the effect of trade costs on bilateral trade and, third, we show how bilateral trade can be used to draw inferences about desired trade balances and desired intertemporal trade. Our econometric results provide strong support for the Obstfeld and Rogoff hypothesis and we are also able to reconcile our results with the so-called home bias puzzle. © Springer Science+Business Media, LLC 2008.