Hi,

If our objective is to ascertain the relationship (specifically, sign and significance of Beta coefficient) between independent variables and dependent variable in an OLS regression (cross sectional or time series or panel regressions), should we actually care about an appropriate functional form of the independent variables? I have observed that in order to establish such relationship and to explain variation in the dependent variable, research papers keep on suggesting fresh set of variables as potential determinants of dependent variable without discussing the issue of functional form. For example, in majority of corporate finance research, some financial variables (explanatory variables) are picked up from the financial statements to explain variation in another financial variable (dependent variable) without even making a mention of the issue of functional form.

However, I have read in Gujarati (2009) that one must transform an independent variable by looking at its graphical relationship with dependent variable and then include it in the model. Further, I also have not come across a research paper which reports the results of RAMSEY RESET to suggest the appropriateness of the functional forms used by them in the model.

Thanks!