Krdytkyu

Suppose I am interested in a linear regression model, for $$Y_i = beta_0 + beta_1x_1 + beta_2x_2 + beta_3x_1x_2$$, because I would like to see if an interaction between the two covariates have an effect on Y.

In a professors' course notes (whom I do not have contact with), it states:
When including interaction terms, you should include their second degree terms. ie $$Y_i = beta_0 + beta_1x_1 + beta_2x_2 + beta_3x_1x_2 +beta_4x_1^2 + beta_5x_2^2$$ should be included in the regression.

Why should one include second degree terms when we are only interested in the interactions?

It depends on the goal of inference. If you want to make inference of whether there exists an interaction, for instance, in a causal context (or, more generally, if you want to interpret the interaction coefficient), this recommendation from your professor does make sense, and it comes from the fact that misspecification of the functional form can lead to wrong inferences about interaction.

Here is a simple example where there is no interaction term between $x_1$ and $x_2$ in the structural equation of $y$, yet, if you do not include the quadratic term of $x_1$, you would wrongly conclude that $x_1$ interacts with $x_2$ when in fact it doesn't.

set.seed(10)

n <- 1e3

x1 <- rnorm(n)

x2 <- x1 + rnorm(n)

y <- x1 + x2 + x1^2 + rnorm(n)

summary(lm(y ~ x1 + x2 + x1:x2))



Call:

lm(formula = y ~ x1 + x2 + x1:x2)



Residuals:

    Min      1Q  Median      3Q     Max 

-3.7781 -0.8326 -0.0806  0.7598  7.7929 



Coefficients:

            Estimate Std. Error t value Pr(>|t|)    

(Intercept)  0.30116    0.04813   6.257 5.81e-10 ***

x1           1.03142    0.05888  17.519  < 2e-16 ***

x2           1.01806    0.03971  25.638  < 2e-16 ***

x1:x2        0.63939    0.02390  26.757  < 2e-16 ***

---

Signif. codes:  0 ‘***’ 0.001 ‘**’ 0.01 ‘*’ 0.05 ‘.’ 0.1 ‘ ’ 1



Residual standard error: 1.308 on 996 degrees of freedom

Multiple R-squared:  0.7935,    Adjusted R-squared:  0.7929 

F-statistic:  1276 on 3 and 996 DF,  p-value: < 2.2e-16

This can be interpreted as simply a case of omitted variable bias, and here $x_1^2$ is the omitted variable. If you go back and include the squared term in your regression, the apparent interaction disappears.

summary(lm(y ~ x1 + x2 + x1:x2 + I(x1^2)))   



Call:

lm(formula = y ~ x1 + x2 + x1:x2 + I(x1^2))



Residuals:

    Min      1Q  Median      3Q     Max 

-3.4574 -0.7073  0.0228  0.6723  3.7135 



Coefficients:

              Estimate Std. Error t value Pr(>|t|)    

(Intercept) -0.0419958  0.0398423  -1.054    0.292    

x1           1.0296642  0.0458586  22.453   <2e-16 ***

x2           1.0017625  0.0309367  32.381   <2e-16 ***

I(x1^2)      1.0196002  0.0400940  25.430   <2e-16 ***

x1:x2       -0.0006889  0.0313045  -0.022    0.982    

---

Signif. codes:  0 ‘***’ 0.001 ‘**’ 0.01 ‘*’ 0.05 ‘.’ 0.1 ‘ ’ 1



Residual standard error: 1.019 on 995 degrees of freedom

Multiple R-squared:  0.8748,    Adjusted R-squared:  0.8743 

F-statistic:  1739 on 4 and 995 DF,  p-value: < 2.2e-16

Of course, this reasoning applies not only to quadratic terms, but misspecification of the functional form in general. The goal here is to model the conditional expectation function appropriately to assess interaction. If you are limiting yourself to modeling with linear regression, then you will need to include these nonlinear terms manually. But an alternative is to use more flexible regression modeling, such as kernel ridge regression for instance.

The two models you listed in your answer can be re-expressed to make it clear how the effect of $X_1$ is postulated to depend on $X_2$ (or the other way around) in each model.

The first model can be re-expressed like this:

$$Y = beta_0 + (beta_1 + beta_3X_2)X_1 + beta_2X_2+ epsilon,$$

which shows that, in this model, $X1$ is assumed to have a linear effect on $Y$ (controlling for the effect of $X_2$) but the the magnitude of this linear effect - captured by the slope coefficient of $X_1$ - changes linearly as a function of $X_2$. For example, the effect of $X_1$ on $Y$ may increase in magnitude as the values of $X_2$ increase.

The second model can be re-expressed like this:

$$Y = beta_0 + (beta_1 + beta_3X_2)X_1 + beta_4 X_1^2 + beta_2X_2 +beta_5X_2^2 + epsilon,$$

which shows that, in this model, the effect of $X_1$ on $Y$ (controlling for the effect of $X_2$) is assumed to be quadratic rather than linear. This quadratic effect is captured by including both $X_1$ and $X_1^2$ in the model. While the coefficient of $X_1^2$ is assumed to be independent of $X_2$, the coefficient of $X_1$ is assumed to depend linearly on $X_2$.

Using either model would imply that you are making entirely different assumptions about the nature of the effect of $X_1$ on $Y$ (controlling for the effect of $X_2$).

Usually, people fit the first model. They might then plot the residuals from that model against $X_1$ and $X_2$ in turns. If the residuals reveal a quadratic pattern in the residuals as a function of $X_1$ and/or $X_2$, the model can be augmented accordingly so that it includes $X_1^2$ and/or $X_2^2$ (and possibly their interaction).

Note that I simplified the notation you used for consistency and also made ther error term explicit in both models.