Trade Effects of the Europe Agreements : A Theory-Based Gravity Approach

In this paper, we develop a new version of a theory-based gravity equation to properly account for the relative price indices initially proposed by Anderson and van Wincoop (2003). The partially time-varying character of our multilateral resistance variables overcomes the bias present in earlier studies that solely rely on country or country pair fixed effects. Applying the augmented gravity equation to the process of European Union (EU) integration during the 1990s, we find robust evidence that the Free Trade Agreements (FTAs) with the Central and Eastern European Countries (CEECs) have substantially increased intra-group trade, in the case of the Czech and Slovak Republic and Slovenia at the expense of the Rest of the World (ROW). Since decreasing multilateral trade resistance negatively influences a country’s bilateral imports but may be positively correlated with a bilateral FTA, earlier East-West studies, which ignored the relative price term’s time-varying character, tend to be downward biased. Indeed, our results indicate that once we correct for the omitted variable bias, the FTAs with the CEECs created 7 to 20% more new trade compared with the scenario where only time-invariant country pair effects were included