Regime switching models

Abstract

Many economic time series occasionally exhibit dramatic breaks in their behavior, asso- ciated with events such as financial crises (Jeanne andMasson, 2000; Cerra, 2005; Hamilton, 2005) or abrupt changes in government policy (Hamilton, 1988; Sims and Zha, 2004, Davig, 2004). Of particular interest to economists is the apparent tendency of many economic variables to behave quite differently during economic downturns, when underutilization of factors of production rather than their long-run tendency to grow governs economic dynam- ics (Hamilton, 1989, Chauvet and Hamilton, 2005). Abrupt changes are also a prevalent feature of financial data, and the approach described below is quite amenable to theoretical calculations for how such abrupt changes in fundamentals should show up in asset prices (Ang and Bekaert, 2003; Garcia, Luger, and Renault, 2003; Dai, Singleton, andWei, 2003).