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

Ryan Compton and Jose Silva

No 97, Working Papers Series from Central Bank of Brazil, Research Department

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.

Date: 2005-08
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