Finance and the Business Cycle: a Kalman Filter Approach with Markov Switching

Abstract

This paper combines two popular econometric tools, the dynamic factor model and the Markov-Switching model, to consider three segments of the financial system- the stock market, debt, and money- and their contribution to US business cycles over the past four decades. The dynamic factor model identifies a composite factor index for each financial segment, and using Markov-switching models by Hamilton (1989) and Filardo (1994), this paper then estimates the effect of each segment index on business cycle behaviour. This reexamination of the finance-business cycle link provides results that prove strongest for the effect of stock market movements on business cycles.