Multiple Regression – How to Use an Index in a Multiple Regression

econometricsmultiple regressionpanel datatime series

I'm performing a multiple regression to see whether the free trade agreement (FTA) between South Korea and the EU had an effect upon the bilateral trade. I am regressing my dependent variable (bilateral trade) upon 4 independent variables:

  • x1= GDP (nominal data)
  • x2= CPI
  • x3= NEER (the nominal effective exchange rate), which is an index number
  • x4= dummy variable for the FTA.

I am using quarterly panel data computed for 10 years for all 22 countries included in the FTA. I am a bit confused how to use the fourth variable, the index number in this multiple regression. The base year of the data set I found (from the IMF) is 2010. How do I put this index (NEER) in my regression? Do I use the changes of the index in my regression, with log? And how can I interpret this variable? An increase of 1 (1%) in the index is a increase of … in the dependent variable?

Best Answer

You go right ahead and include that index (in levels) in the model you wish to estimate. The interpretation is the same always, when the x increase by 1 y increase by $\beta$.

You can log the index, provided it is never 0. Then you have a standard level-log model, with the semi elastic interpretation.

Also note (if you log the index), you can rescale the index to any base year you wish. It does not make any difference for the estimate. It will however change the intercept, but very often one does not care about the intercept.

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