Measuring response of output growth to changes in yield spread in a state switching framework

Abstract

This paper explores the dynamic relationship between the yield spread and the growth rate of output when the economic states are driven by a hidden Markov chain. The results for three industrialised countries (USA, UK and Japan) confirm that the response of output growth rate to yield spread is more effectively captured by this state switching approach than a single state model. The two distinct states are characterised by the levels of growth rates, volatility and risk-aversion. This also allows us to analyze the international co-movements of the economic states between these countries using a non-parametric measure of concordance. We detect strong co-movements of the economic states between USA and Japan over the sample period. We then postulate that the U.S. yield spread might have explanatory power over and above the domestic yield spread in explaining the economic activity in Japan. We are able to confirm this assertion when we extend the model, but only in case Japan. In the case of UK, the domestic yield spread retains the dominant influence.