Solving the Puzzle: A New Measure of Trade Distance In The Gravity Equation

The gravity equation model is a workhorse tool that has been used many times in international trade. However, one philosophical and empirical question that arises when this theory is applied in this ?eld is what is the relevant measure of distance. This question is easily solved in physics, which is the ?eld where this theory was originally developed, but there is not clear answer in international trade. Therefore, we propose an index of distance based on principal component analysis that summarizes in one factor information related to geographical, cultural, political and economic variables that might a?ect international trade between countries. We use this index as proxy of distance, and Gross Domestic Product as proxy of mass, and we run some panel data exercises between 1995 and 2000 for 10 Latin American economies. Estimations indicate that the sign of the load factors in the principal component analysis are intuitively plausible, and that panel data exercises give sensible robust outcomes.