Spurious Regressions and Near-Multicollinearity, with an Application to Aid, Policies and Growth

Abstract

In multiple regressions, explanatory variables with simple correlation coefficients with the dependent variable below 0.1 in absolute value (such as aid with economic growth) may have very large and statistically significant estimated parameters which are unfortunately "outliers driven" and spurious. This is obtained by including another regressor which is highly correlated with the initial regressor, such as a lag, a square or interaction terms of this regressor. The analysis is applied on the "Botswana outliers driven" Burnside and Dollar [2000] article which found that aid had an effect on growth only for countries achieving "good" macroeconomic policies.

Keywords: Near-Multicollinearity, Student t-Statistic, Spurious regressions, Ceteris paribus, Parameter Inflation Factor, Growth, Foreign Aid

JEL Classification: C12, C52, F35, O19, O47, P45