Granger-causality in Markov switching models

In this paper, we propose a new approach for characterizing and testing Granger-causality, which is well equipped to handle models where the change in regime evolves according to multiple Markov chains. Differently from the existing literature, we propose a method for analysing causal links that specifically takes into account Markov chains. Tests for independence are also provided. We illustrate the methodology with an empirical application, and in particular, we investigate the causality and interdependence between financial and economic cycles in USA using the bivariate Markov switching model proposed by Hamilton and Lin 13 J.D. Hamilton and J. Lin, Stock market volatility and business cycle, J. Appl. Econ. 11(5) (1996), pp. 573–593. doi: 10.1002/(SICI)1099-1255(199609)11:5<573::AID-JAE413>3.0.CO;2-TCrossref], Web of Science ®] , Google Scholar]]. We find that financial variables are useful in forecasting the aggregate economic activity, and vice versa.