Latent Leading and Coincident Factors Model with Markov-Switching Dynamics

This paper introduces a two-factor model of leading and coincident economic indicators. The common leading factor is assumed to Granger-cause the common coincident factor. This property is used to estimate the two common factors simultaneously and hence more efficiently. Two models of the latent leading and coincident factors are studied: a model with linear dynamics and a model with Markov-switching dynamics introduced through the leading factor intercept term. The first model encompasses the comovements between the individual time series. The second model, moreover, takes care of possible asymmetries between the business cycle regimes.