## Econometrics — a matter of BELIEF and FAITH

11 Feb, 2020 at 16:01 | Posted in Statistics & Econometrics | Comments Off on Econometrics — a matter of BELIEF and FAITH

Everybody who takes regression analysis course, studies the assumptions of regression model. But nobody knows why, because after reading about the axioms, they are rarely mentioned. But the assumptions are important, because if any one assumption is wrong, the regression is not valid, and the interpretations can be completely wrong. In order to have a valid regression model, you must have right regressors, the right functional form, all the regressors must be exogenous, regression parameters should not change over time, regression residuals should be independent and have mean zero, and many other things as well. There are so many assumptions that it is impossible to test all of them. This means that interpreting a regression model is always a matter of FAITH – we must BELIEVE, without having any empirical evidence, that our model is the ONE TRUE VALID model. It is only under this assumption that our interpretations of regression models are valid …

Nonsense Regressions: If a regression model OMITS a significant regressor then it is INVALID; we may call such regressions “nonsense regressions”.

This formulation highlights the major mistake in modelling that is common. The regressors which are EXCLUDED by a regression model are just as important as the ones that are included. Thus the simple model C not only states that FDI determines GDP, it also states that no other variable has any effect on GDP, since no other variable is included in the model. It is this exclusion which is seriously questionable.