Scandinavian Working Papers in Economics

Working Papers,
Lund University, Department of Economics

No 2004:4: Reconnecting the Markov Switching Model with Economic Fundamentals

Ulf Erlandsson
Additional contact information
Ulf Erlandsson: Department of Economics, Lund University, Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund, Sweden

Abstract: 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.

Keywords: regime switching; transition probability; forecasting

JEL-codes: C13; C32; E32

28 pages, First version: January 27, 2004. Revised: November 4, 2004. Earlier revisions: March 18, 2004, November 4, 2004.

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