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Changes in the Factor Structure of the U.S. Economy: Permanent Breaks or Business Cycle Regimes?

Luke Hartigan ()

No 2015-17, Discussion Papers from School of Economics, The University of New South Wales

Abstract: The factor structure of the U.S. economy appears to change over time. Unlike previous studies which suggest this is due to permanent structural breaks in factor loadings, I argue instead that the volatility and persistence of factor processes undergo recurring changes related to the business cycle. To capture this, I develop a two-step Markov-switching static factor estimation procedure and apply it to a well-studied U.S. macroeconomic data set. I find strong support for Markov-switching in the factors processes, with switching variances being most dominant. Conditional on Markov-switching factor processes, tests for regime-dependent factor loadings show only moderate evidence of change. Overall, the results support regime-dependent factor processes as the main explanation for the diverging number of estimated factors in empirical applications and challenge the global linearity assumption implicit in large dimensional factor models of the U.S. economy.

Keywords: Approximate Factor Model; Large Data Sets; Markov Switching Model; Structural Breaks (search for similar items in EconPapers)
JEL-codes: C32 C38 C51 C55 E32 (search for similar items in EconPapers)
Pages: 32 pages
Date: 2015-09
New Economics Papers: this item is included in nep-bec, nep-ecm and nep-mac
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