Trade, gravity and cross-sectional dependence

We study how empirical analyses of trade flows based on the gravity model are affected by cross-sectional dependence (CSD) using novel panel data of trade between countries and regions of the European Union, which permits comparisons at different levels of aggregation. We document that CSD is not a problem when the model is estimated with country-level flows, but is a problem in estimations with more disaggregate region-level flows. This is due to local spatial dependence, which is not accounted for in common implementations of the model with fixed effects, but can be captured by including spatial lags into the model.