The Concept of Gravity Model

16 developed the first gravity model equations through the specification of total exports as a function of the Gross National Product GNP and distance between the countries Kien, 2009. Bergstrand 1989 further developed this model by clarifying that it is not only useful for analyzing trade as a whole, but can also be applied to the trade flow of a specific commodity. Moreover, according to Alonso 1987, a strong association can be found in relation to gravity, by replacing the function of the mass with the population and the strength of the gravitational interaction with distance between two countries Yuniarti, 2007. The gravity model is used to analyze the economic factors that affect the flow of trade between two countries. According to Lineman Lapipi, 2005, the gravity model is an econometric model that is used to analyze the effects of economic integration on trade, as well as being an analytical tool that can be used to estimate the value of exported and imported goods in a region. The formulation of the gravity model was adopted from the general equation of Newtons law of gravity, which states, The interaction between two objects is proportional to its mass and inversely proportional to the distance of each object. The statement is applied in the following formula: ��� = � � �� �� ��� where F equals the volume of interaction between the two countries bilateral trade flows, M denotes the size of the economy for both countries, D represents the distance of both countries and G is the constant. Furthermore, through a logarithmic equation, the equation is converted into a linear form for the econometric analysis to provide a general form for gravity models. In this case, the constant G is converted into β0 and GDP is used as a measure for the economy of both countries. Log bilateral trade flow = β0 + β1 log GDP country 1 + β2 log GDP country2 + β3 log distance + ε Thus, the general formula of gravity models according to Bergstrand 1989, Koo, et al 1994 in Oktaviani 2009 is as follows: Tij = f Yi, Yj, Fij where Tij equals the value of trade flow from country i to country j, Y i represents the GDP of country i, Y j is the GDP for country j, and F ij denotes other factors that influence trade between country i and country j. Gravity models present a more empirical analysis of trading patterns compared with other theoretical models, because they predict trade based on the distance between countries and the interaction of the country’s economy. In econometrics, gravity models are empirically proven to be robust by including other factors such as income level, diplomatic relations and trade policies. Initially, gravity model theories had a weak theoretical basis, but over the years they have become very popular and more reliable in empirical studies of international trade flows. Gravity models are very popular for several reasons; first, the gravity model is the modern theory of trade, which is widely used to analyze economic issues in the region. It has been shown to have empirical success because it presents a more 17 empirical analysis of trading patterns compared with the other econometrics model which only predict full specialization of a country in commodity production and does not account for supporting factors such as the relative amounts of labor and capital in the country. Second, gravity models have been quite successful in estimating the trade flows between countries over the years. Third, more attention has been focused on empirically examining the trade impacts of a regional trade regulations Frankel 1997 in Ghosh, et al., 2005. Figure 6 Operational Framework Essentially, the gravity model explains the flow of trade based on the distance between countries and the interaction between the sizes of each country’s economy GDP. The flow of trade between countries is determined by several variables, namely: the variables that represent the total potential demand of the importing country which can be described by real GDP of the importing country, the total potential supply of the exporting country which can be described by the real GDP or production of a commodity of the exporting country, and the variables that either support or inhibit the flow of trade between the two countries, for instance, distance, remoteness export commodity prices, exchange rates, export policies, and regional trade agreements Figure 6.

3.4 Export and Exchange Rate

Foreign currency derived from export supply. Figure 7 shows how the impact of exchange rate changes on a country A exports to the Rest of the World ROW. Initial equilibrium is at the world price Pw and exports qe. 18 Appreciation in the exchange rate of country A will shift the excess demand from the ED to ED’ vecause ROW only be willing to pay a lower price. At the end of this condition will cause the domestic price in country A dropped, increasing the price in ROW, lowering exports from country A, and reducing imports in ROW. The impact of the appreciation of currency of the country A is the increase of foreign currency exchange rate in any amount and increase the price in the ROW. This condition will cause the shifting from ES into ES’. Implicitly, the revaluation effect as implicit export taxes, because it lowers the amount of exports at any price level. Figure 7 also shows that the appreciation in currency of country A cause prices to go down from Pw to Pa. In other words, the depreciation of the currency in ROW will cause prices to rise from the initial equilibrium becomes Pr Tweeten, 1992. Figure 7 Currency Revaluation Effect of The Exporting Country Source: Tweeten, 1992 4 METHODS

4.1 Types and Sources of Data

All data used in this study is secondary panel data, which is a combination of time series data and cross-sectional data. Time series data includes annual data from 2003 to 2013, while the cross-sectional data covers ten major export destinations of the three main natural rubber exporting countries, with the largest Country A Export Market of Country A In the Currency of ROW In the Currency of Country A