Residualization: justification, properties and application

Abstract

Although it is usual to find collinearity in econometric models, it is commonly disregarded. An extended solution is to eliminate the variable causing the problem but, in some cases, this decision can affect the goal of the research. Alternatively, residualization not only allows mitigation of collinearity, but it also provides an alternative interpretation of the coefficients isolating the effect of the residualized variable. This paper fully develops the residualization procedure and justifies its application not only for dealing with multicollinearity but also for separating the individual effects of the regressor variables. This contribution is illustrated by two econometric models with financial and ecological data, although it can also be extended to many different fields.