International trade flows are volatile, imbalanced, and fragmented across off-shored supply chains. Yet, not much is known about the mechanism through which trade flows adjust in response to shocks over time. This paper derives a dynamic gravity equation from a theory of habits in the supply chains that generates autocorrelated bilateral trade flows that are heterogeneous across different country pairs. We estimate our version of the dynamic gravity equation for 39 countries over the period of 1950-2014 and find that the transmission of local and global trade shocks is fundamentally different. We show that the trade persistence coefficient falls from 0.91 to 0.35 when we depart from the existing empirical gravity models that draw inference from the pooled coefficient estimates without controlling for the variation in the unobservable global factors. Thus, our approach escapes the excess trade persistence puzzle and adds to the explanation of the sharp decline and the rapid recovery of the global trade flows during the "Great Trade Collapse" of 2008-09. In addition to the traditional variables in the gravity equation, we also show that a cross-country habit asymmetry creates bilateral and multilateral trade imbalances, which are an important determinant of bilateral trade flows both theoretically and empirically.
Keywords: Dynamic Gravity Equation; Habits; Trade Persistence; Trade Imbalance; Global Shocks; Parameter Heterogeneity.
JEL codes: C23, F14, F41, F62.
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