Question

Provide explanation and justification on the following:
a. How to select the different functional forms?
b. How to interpret the results from econometric/statistical view?
c. What are the possible diagnostic problems?
d. How to overcome the diagnostic problems?
e. Others relevant econometric aspects

Answer 1

a.)

Knowledge from previous studies and economic theory can be used to decide upon the correct functional form in any regression model.

b.)

The model will be of the form -

Here, B0 is the autonomous value of dependent variable Y which is not affected by the value of independent variable X, B1 is the coefficient by which value of X affects the value of Y, and e is the error terms which captures the impact of all other factors affecting the value of Y apart from variable X.

c.)

Some of the diagnostic problems are -

• Autocorrelation
• Heteroscedasticity
• Wrong functional forms

d.)

To overcome these problems, there are several tests to help detect these problems and then ways to correct them -

Problem	Test to detect	Correction method
Autocorrelation	Durbin-Watson test	Take the first difference, use a different functional form
Heteroscedasticity	White's test	Convert to Generalised Least Square estimation
Wrong functional form	Ramay RESET test	Use a different functional form

e.)

Other relevant economic aspects in this model can be the significance of the model and the variables. The model can predict a relationship but the relationship will be useless if the model predicts it is not significant. Hence, the t-statistic value and the p-value of the coefficient B1 and the F-value of the entire model along with the R2 value have to be examined.