Comparing probability forecasts in Markov regime switching business cycle methods

Smith, Daniel R. and Layton, Allan P. (2007) Comparing probability forecasts in Markov regime switching business cycle methods. Journal of Business Cycle Measurement and Analysis, 3 (1). pp. 79-98. ISSN 1729-3618

Abstract

We evaluate techniques for comparing the ability of Markov regime switching (MRS) models to fit underlying regimes of a series of interest. This is particularly important in the business cycle literature where one may be interested in determining whether using leading indicators to allow transition probabilities to vary improves the ability of MRS models to fit the NBER business cycle chronology. This is typically done using the quadratic probability score, or QPS (Diebold and Rudebusch (1989)). Although it is possible to statistically compare the QPS statistics for two MRS models using the Diebold and Mariano (1995) (DM) test statistic for comparing forecasts, we find using a Monte Carlo experiment that the DM statistic tends to under-reject (the null of “no difference in forecast accuracy”) when comparing MRS models. This we believe is because of the strong non-normality of the forecast errors of such models. Furthermore, using simulation-based inference we demonstrate that leading indicators improve the fit of an MRS model of the US business cycle chronology by 24 percent, such improvement having a p-value of 0.001.


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Item Type: Article (Commonwealth Reporting Category C)
Refereed: Yes
Item Status: Live Archive
Depositing User: Mrs Annette Bourne
Faculty / Department / School: Historic - Faculty of Business - No Department
Date Deposited: 22 Nov 2007 22:30
Last Modified: 02 Jul 2013 22:46
Uncontrolled Keywords: Markov regime switching; Diebold and Mariano statistic; quadratic probability score; Monte Carlo; business cycle
Fields of Research (FOR2008): 01 Mathematical Sciences > 0104 Statistics > 010404 Probability Theory
14 Economics > 1401 Economic Theory > 140102 Macroeconomic Theory
14 Economics > 1403 Econometrics > 140303 Economic Models and Forecasting
Socio-Economic Objective (SEO2008): B Economic Development > 91 Economic Framework > 9102 Microeconomics > 910206 Market-Based Mechanisms
Identification Number or DOI: doi: 10.1787/jbcma-v2007-art4-en
URI: http://eprints.usq.edu.au/id/eprint/2715

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