Nonstationarities and Markov Switching Models

Abstract

This paper proposes a flexible model that allows for recent changes observed in the US business cycle in the last six decades. It proposes a Markov switching model with three Markov processes to characterize the dynamics of US output fluctuations. We consider the possibility that both the mean and the variance of growth rates of real GDP can have short run fluctuations in addition to the possibility of a long run permanent break. We find that, differently from several alternative specifications in the literature, the proposed flexible framework successfully represents all business cycle phases, including the Great Recession. In addition, we find that the volatility of US output fluctuations has both a long run pattern, characterized by a structural break in 1984, as well as business cycle dynamics, in which periods of high uncertainty are associated with NBER recessions.