The State-of-The-Economy Index and The probability of Recession: The Markov Regime-Switching Model

This paper offers a new approach to the identification of the business cycle in Israel, using a composite state-of-the-economy index based on the Markov regime-switching model. This model, unlike its predecessor, is not bound by the assumption of symmetry between periods of recession and expansion. The composite index is estimated simultaneously with the probability of the economy being in a recession. Several improvements have been incorporated into the index components: the series of goods exports was included, an appropriate step in the light of the fact that Israel is a small open economy; the lag in the connection between employment and economic activity was also dealt with. The new composite index presents a sharper picture of the business cycle than did the old Bank of Israel index. The new index, with the probability of recession, give an accurate description of the business cycle ex post facto, with regard to their high correlation with the GDP, final uses and employment series, and with regard to identifying the turning points in the cycle in real time. The probability of recession successfully detects a downturn immediately, and more sharply about two months after its onset. The start of expansion, however, takes longer to detect, as occurred with the period of growth in high-tech that began in the second half of 1999. Another advantage of the new index, and particularly of the recession probability, over the old index lies in their being less volatile and less liable to retroactive revisions.