Regime switching with time-varying transition probabilities

Abstract

Abstract The Markov switching model is useful because of the potential it offers for capturing occasional but recurrent regime shifts in a simple dynamic econometric model. Existing treatments, however, restrict the transition probabilities to be constant over time; that is, the probability of switching from one regime to the other cannot depend on the behaviour of underlying economic fundamentals. In contrast, we propose a class of Markov switching models in which the transition probabilities can vary with fundamentals. We develop an EM algorithm for estimation of the model and we illustrate it with a simulation example. We conclude with a discussion of directions for future research, including application to exchange rate and business cycle modelling.