I read conflicting opinions about the inclusion of lagged dependent variables in modeling, and I guess it is partly up to the researcher and depending on the scope and goal of the research.
I'm currently modeling the liquidity of German stocks, with panel data regression (fixed time effects), and my independent variables are price (logged), freefloat number of shares (logged) en book-to-market-value.
Using E-views, my results are OK, except for a Durbin-Watson value around 1.5.
Assuming Durbin Watson is valid for paneldata (but for the seperate stocks, DW is also too low ), we have autocorrelation in the errors.
This is a problem because:.
(i) Estimates of the regression coefficients are inefficient. (ii) Forecasts based on the regression equations are sub-optimal. (iii) The usual significance tests on the coefficients are invalid. [source: Granger]
Including a lagged dependent variable, i.e. liquidity from the day before, solves this issue and as expected increases the R^2 a bit more. But I am not really sure if this is the way to go. This is modeling liquidity where liquidity of the previous day is the most important factor.... Another option would be that I'm missing a independent variable?
Specifically the papers of Achen(To Lag or Not to Lag? Re-evaluating the Use of Lagged Dependent Variables in Regression Analysis) and Wilkins (Why Lagged Dependent Variables Can Supress the Explanatory Power of Other Independent Variables) talk about these issues.