A Factor-Augmented Markov Switching (FAMS) Model

Abstract: This paper investigates the role of high-dimensional information sets in the context of Markov switching models with time varying transition probabilities. Markov switching models are commonly employed in empirical macroeconomic research and policy work. However, the information used to model the switching process is usually limited drastically to ensure stability of the model. Increasing the number of included variables to enlarge the information set might even result in decreasing precision of the model. Moreover, it is often not clear a priori which variables are actually relevant when it comes to informing the switching behavior. Building strongly on recent contributions in the field of factor analysis, we introduce a general type of Markov switching autoregressive models for non-linear time series analysis. Large numbers of time series are allowed to inform the switching process through a factor structure. This factor-augmented Markov switching (FAMS) model overcomes estimation issues that are likely to arise in previous assessments of the modeling framework. More accurate estimates of the switching behavior as well as improved model fit result. The performance of the FAMS model is illustrated in a simulated data example as well as in an US business cycle application.