The global disconnect: The role of transactional distance and scale economies in gravity equations

Recent empirical analyses show that asset flows can be modelled by the same 'gravity' equations that trade economists have used so successfully for the past few decades. This is something of a surprise. Trade economists do not yet have a unified theory of why gravity models should work-and the situation is worse for asset flows. Reasonable theories would predict that greater distance between countries should generate more asset flows rather than less as the econometric results seem to consistently show. In this paper we discuss how host and source country GDPs, language, and distance the core explanatory variables in the traditional gravity models-fare in trade and asset flows estimations. While the 'distance puzzle' is not resolved, it is considerably reduced by going beyond consideration of physical distance to concepts of transactional distance and scale economies.