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Adding Flexibility to Markov Switching Models

Edoardo Otranto

Working Paper CRENoS from Centre for North South Economic Research, University of Cagliari and Sassari, Sardinia

Abstract: Very often time series are subject to abrupt changes in the level, which are generally represented by Markov Switching (MS) models, hypothesizing that the level is constant within a certain state (regime). This is not a realistic framework because in the same regime the level could change with minor jumps with respect to a change of state; this is a typical situation in many economic time series, such as the Gross Domestic Product or the volatility of financial markets. We propose to make the state flexible, introducing a very general model which provides oscillations of the level of the time series within each state of the MS model; these movements are driven by a forcing variable. The flexibility of the model allows for consideration of extreme jumps in a parsimonious way (also in the simplest 2-state case), without the adoption of a larger number of regimes; moreover this model increases the interpretability and fitting of the data with respect to the analogous MS model. This approach can be applied in several fields, also using unobservable data. We show its advantages in three distinct applications, involving macroeconomic variables, volatilities of financial markets and conditional correlations.

Keywords: abrupt changes; goodness of fit; Hamilton filter; smoothed changes; time–varying parameters (search for similar items in EconPapers)
JEL-codes: C22 C32 C5 (search for similar items in EconPapers)
Date: 2015
New Economics Papers: this item is included in nep-ecm, nep-ets and nep-ore
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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https://crenos.unica.it/crenos/node/6529
https://crenos.unica.it/crenos/sites/default/files/WP15-09.pdf (application/pdf)

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Persistent link: https://EconPapers.repec.org/RePEc:cns:cnscwp:201509

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