Identification and Normalization in Markov Switching Models of "Business Cycles"

By Penelope A. Smith and Peter M. Summers
October 2004 
RWP 04-09
Research Division 
Federal Reserve Bank of Kansas City 

Abstract

      Recent work by Hamilton, Waggoner and Zha (2004) has demonstrated the importance of identification and normalization in econometric models. In this paper, we use the popular class of two-state Markov switching models to illustrate the consequences of alternative identification schemes for empirical analysis of business cycles. A defining feature of (classical) recessions is that economic activity declines on average. Somewhat surprisingly however, this property has been ignored in most published work that uses Markov switching models to study business cycles. We demonstrate that this matters: inferences from Markov switching models can be dramatically affected by whether or not average growth in the 'low state' is required to be negative, rather than simply below trend. Although such a restriction may not be appropriate in all applications, the difference is crucial if one wants to draw conclusions about 'recessions' based on the estimated model parameters.

Keywords: Business cycles, Recessions, Markov switching, Beyasian inference, Posterior distribution

JEL Codes: E32, E37, C22

Penelope A. Smith is a Research Fellow and Peter M. Summers is an Associate Professor at The University of Melbourne. Peter is a visiting scholar at the Federal Reserve Bank of Kansas City. The authors wish to thank Todd Clark, James Hamilton, Don Harding, and Adrian Pagan for helpful comments and Chang-Jin Kim for providing them with his data. Computations in this paper were carried out, in part, using the BACC software developed by John Geweke and Siddhartha Chib (http://www.econ.umn.edu/˜bacc/), and James LeSage’s Applied Econometrics Toolbox for Matlab (www.spatial-econometrics.com). The authors retain all responsibility for any remaining errors. The views expressed herein are those of the authors and do not necessarily represent those of the Federal Reserve Bank of Kansas City or the Federal Reserve System.

Smith email:  pasmit@unimelb.edu.au
Summers email:  peter.summers@kc.frb.org

Back to top       RWP home