Imes Discussion Paper Series Institute for Monetary and Economic Studies Bank of Japan

In the dynamic factor model, a single unobserved factor common to some macroeconomic variables is defined as a composite index to measure business cycles. This model has recently been developed by combining with the regime-switching model so that the mean growth of the index may shift depending on whether the economy is in the boom regime or in the recession regime. An advantage of this dynamic Markov switching factor model is that estimating the model by a Bayesian method produces the posterior probabilities that the economy is in the recession regime, which can be used to date the business cycle turning points. This article estimates the dynamic Markov switching factor model using some macroeconomic variables in Japan. The model comparison using Bayes factor does not provide strong evidence that the mean growth of the index shifts, but the dynamic Markov switching factor model is found to produce the estimates of turning points close to the reference dates by the Economic and Social Research Institute in Cabinet Office unless only weakly correlated variables are used.