Interaction Term

An interaction term results from the product of one binary variable by another
explanatory variable, knowing that said variable can be either quantitative or binary.
An interaction term allows the effect of the second variable of the product to be
different according to the group to which the first variable indicates that the country
belongs. Opposing to the individual change on the value of the constant term when
only considering a dummy variable.
According to our data we chose to set the interaction as the product between the
variables X 5∗X 1.
Therefore, our model will look like the following
Y i=β 1 + β 2 X 1i + β 3 X 2 i+ β 4 X 3 i+ β5 X 4 i+ β6 X 5 i∗X 1 i+ ε i

Now, separating our data by groups

 Country belongs to the European union X 5 =1:

Y i=β 1 + ( β 2 + β 6 ) X 1 i+ β 3 X 2 i + β 4 X 3 i + β 5 X 4 i+ ε i

 Country belongs to the European union X 5 =0:

Y i=β 1 + β 2 X 1i + β 3 X 2 i+ β 4 X 3 i+ β5 X 4 i+ ε i

Thereby we can conclude that β 5=0.007398 is the difference in the effect of an

increase of 1 percentage point on the growth of the foreign direct investment on the
growth of the GDP between countries that belong to the EU and countries that do
not.
Now testing for the functional form, we will once again perform a RESET test. If we
do not reject the null we will end up accepting the linear function form, if we reject the
null, we will need to change the model’s functional form.
Analyzing the p-value below presented p−value=0.6433 we will not reject the null,
thereby concluding that the linear functional form is adequate.
Additionally, we decided to test the functional form of the model by transforming
either the dependent variable or the dependent variable and one of the explanatory
variables, as follows.
Firstly, we decided to take the log of the dependent variable, obtaining the following
results

Repeating the process, we get a p-value of 17.43% which means that we will not
reject the null, therefore the log-linear functional form is adequate albeit not the
optimal one.

Then, we decided to test the functional form of the model composed by the log of the
dependent variable and the log of one of the explanatory variables.
Analyzing the p-value resulting from the reset test, p−value=0.08519> 0.05, the
conclusion is the same as the conclusion from the previous RESET tests. The
functional form of this model is adequate.

Furthermore, we felt the need to analyze the functional form of the model where we
take the logarithms of all variables. Bearing in mind that some of our values in
certain variables are negative, we must add a constant in order to ensure that the
values are positive, thereby allowing us to proceed in the desired manner. In doing
so we must consider the possible changes in the value of β 1.

Analyzing the p-value resulting from the reset test, p−value=0.4727>0.05, the
conclusion is the same as the conclusion from the previous RESET tests. The
functional form of this model is adequate.

Finally, comparing the four p-values that result from the RESET tests we can
conclude that the linear form is the optimal functional form for our model