Testing the Linder Hypothesis for country groups at different income levels: An application of a gravity model

While traditional international trade theories focus on countries' factors of production to explain foreign trade, new theories developed since the 1970s emphasize the importance of demand. In this context, the Linder Hypothesis, also referred to as the Theory of Similar Preferences, takes an important place within modern theories. The Linder Hypothesis posits that trade will be more intense among countries with similar consumer demands. This hypothesis highlights the importance of similar demands. The aim of this thesis is to examine how the factors determining international trade vary according to countries' income levels and to test the validity of the Linder Hypothesis for countries with different incomes. The study employs panel data comprising 66 countries for the 1990-2021 period. Export and import equations are estimated using a gravity model augmented with the real exchange rate, Linder variable, and traditional gravity variables such as GDP and distance. According to the findings, a positive relationship between countries' GDP and their trade has been observed, while an increase in the real exchange rate has a negative effect on trade. The findings support the Linder hypothesis for the whole data set, as well as for upper-middle-income and high-income group. This implies that these countries tend to trade more with countries that have similar income levels. On the other hand, Linder variable is not found to be statistically significant for lower-middle income country group implying that the Linder hypothesis does not hold for these countries.