On modeling heterogeneity in linear models using trend polynomials
Journal
Economic Modelling
Date Issued
February 2020
Author(s)
DOI
10.1016/j.econmod.2019.05.008
Abstract
The primary aim of the paper is to consider the problems and issues raised when the data exhibit time heterogeneity in the context of linear models. Ignoring time heterogeneity will undermine the reliability of inference and will give rise to untrustworthy evidence. Accounting for it using trend polynomials, however, is non-trivial because it raises several modeling issues. First, when the degree of the polynomial is greater than 4, or so, one needs to deal with the near-multicollinearity problem that arises. The second issue pertains to the type of polynomial that will adequately account for the time heterogeneity. Third, when the trend polynomials are treated as additional regressors, they will give rise to highly misleading statistical results. The paper investigates how different types of polynomials could deal with the near-multicollinearity and the modeling issues they raise, and makes recommendations to practitioners.