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Reconnecting the Markov Switching Model with Economic Fundamentals

  • Erlandsson, Ulf

    (Department of Economics, Lund University)

This paper seeks to investigate and remedy the apparent inability of Markov regime switching models to predict future states in the medium to long term. We show that projected time varying transition probability series in the model may be biased towards predicting regime switches with high probability in the short run, and as a consequence it is hard or impossible to obtain longer run inference. We propose a penalized maximum likelihood estimator where non-smoothness in the transition series has negative influence on the likelihood function, which is shown to remedy the short run bias. In an empirical investigation of U.S. real GDP, the penalized model works better in terms of forecasting future recessions as defined by the NBER business cycle dating.

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File URL: http://project.nek.lu.se/publications/workpap/Papers/WP04_4.pdf
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Paper provided by Lund University, Department of Economics in its series Working Papers with number 2004:4.

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Length: 28 pages
Date of creation: 27 Jan 2004
Date of revision: 18 Mar 2004
Handle: RePEc:hhs:lunewp:2004_004
Contact details of provider: Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund,Sweden
Phone: +46 +46 222 0000
Fax: +46 +46 2224613
Web page: http://www.nek.lu.se/en

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  1. Yin-Wong Cheung & Ulf G. Erlandsson, 2004. "Exchange Rates and Markov Switching Dynamics," CESifo Working Paper Series 1348, CESifo Group Munich.
  2. Tobias Rydén & Timo Teräsvirta & Stefan Åsbrink, 1998. "Stylized facts of daily return series and the hidden Markov model," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 13(3), pages 217-244.
  3. Gray, Stephen F., 1996. "Modeling the conditional distribution of interest rates as a regime-switching process," Journal of Financial Economics, Elsevier, vol. 42(1), pages 27-62, September.
  4. Filardo, Andrew J. & Gordon, Stephen F., 1998. "Business cycle durations," Journal of Econometrics, Elsevier, vol. 85(1), pages 99-123, July.
  5. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
  6. Francis X. Diebold & Joon-Haeng Lee & Gretchen C. Weinbach, 1993. "Regime switching with time-varying transition probabilities," Working Papers 93-12, Federal Reserve Bank of Philadelphia.
  7. Kim, C-J., 1991. "Dynamic Linear Models with Markov-Switching," Papers 91-8, York (Canada) - Department of Economics.
  8. Abdul Abiad, 2003. "Early Warning Systems; A Survey and a Regime-Switching Approach," IMF Working Papers 03/32, International Monetary Fund.
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