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Predicting Ordinary and Severe Recessions with a Three-State Markov-Switching Dynamic Factor Model

Author

Listed:
  • Kai Carstensen

    () (University of Kiel, Ifo Institute, CESifo)

  • Markus Heinrich

    () (University of Kiel)

  • Magnus Reif

    () (University of Kiel, Ifo Institute)

  • Maik H. Wolters

    () (University of Jena, Kiel Institute for the World Economy, IMFS at Goethe University Frankfurt)

Abstract

We estimate a Markow-switching dynamic factor model with three states based on six leading business cycle indicators for Germany preselected from a broader set using the Elastic Net soft-thresholding rule. The three states represent expansions, normal recessions and severe recessions. We show that a two-state model is not sensitive enough to reliably detect relatively mild recessions when the Great Recession of 2008/2009 is included in the sample. Adding a third state helps to clearly distinguish normal and severe recessions, so that the model identifies reliably all business cycle turning points in our sample. In a real-time exercise the model detects recessions timely. Combining the estimated factor and the recession probabilities with a simple GDP forecasting model yields an accurate nowcast for the steepest decline in GDP in 2009Q1 and a correct prediction of the timing of the Great Recession and its recovery one quarter in advance.

Suggested Citation

  • Kai Carstensen & Markus Heinrich & Magnus Reif & Maik H. Wolters, 2019. "Predicting Ordinary and Severe Recessions with a Three-State Markov-Switching Dynamic Factor Model," Jena Economic Research Papers 2019-006, Friedrich-Schiller-University Jena.
  • Handle: RePEc:jrp:jrpwrp:2019-006
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    More about this item

    Keywords

    Markov-Switching Dynamic Factor Model; Great Recession; Turning Points; GDP Nowcasting; GDP Forecasting;

    JEL classification:

    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications

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