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Applied Economics
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A further note on the three phases of the US

business cycle
Allan P. Layton & Daniel Smith
Published online: 04 Oct 2010.

To cite this article: Allan P. Layton & Daniel Smith (2000) A further note on the three phases of the US business cycle,
Applied Economics, 32:9, 1133-1143, DOI: 10.1080/000368400404272

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 Applied Economics, 2000, 32, 1133 ± 1143

A further note on the three phases of the

US business cycle
A L L A N P. L A Y T ON and D A N I E L S M I T H
School of Economics and Finance, Queensland University of T echnology,
GPO Box 2434, Brisbane, Australia, 4001
E-mail: a.layton@ qut.edu.au and dr.smith@qut.edu.au

Using a number of alternative approaches, Sichel (1994) demonstrated evidence

supporting the notion that the US business cycle is best characterized as having
three distinct phases, viz. contraction, followed by rapid expansion during the
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early stages of the recovery phase, followed by a period of more normal expansion-
ary growth, with the cycle then repeating itself. This contrasts with the more usual
expansion/contraction, two phase characterization but is more in keeping with the
original notion of the business cycle as conceived by Burns and Mitchell (1946). Here
an alternative approach is employed for shedding light on this issue. Following the
original suggestion of Hamilton (1989, 1990, 1991), a simple nonlinear, three phase,
regime switching Markov model is compared against its simpler two phase version to
determine which version is statistically more consistent with the business cycle his-
torical evidence. The evidence seems to clearly support the three phase characteriza-
tion and that this characterization yields interesting information on business cycle
dynamics which is necessarily missed by the two phase model formulation.

I . I N T R OD U C T I ON simple three regime Markov model is compared with a

As Sichel (1994) noted, it has long been thought that the
business cycle is best characterized as a period of contrac-
tion, followed by abnormally fast growth as the economy
accelerates back to more normal activity, leading then to
an expansionary period of slower, but more sustainable
normal growth (see Burns and Mitchell, 1946 and
Schultze, 1964). Sichel went on to provide several di€ erent
forms of evidence supporting the proposition of a three
phase business cycle and argued the driving force behind
the three phases was inventory investment.
In what follows the three phase hypothesis is tested
within the framework of the Markov, probabilistic
regime-switching modelling approach originally suggested
by Hamilton (1989, 1990, 1991). In doing this the two
regime framework employed by Hamilton is extended to
a three regime environment (Boldin, 1990 has also used a
similar model in a related context). In particular, using a
time series known to closely re¯ ect the US business cycle, a
Applied Economics ISSN 0003± 6846 print/ISSN 1466± 4283 online # 2000 Taylor & Francis Ltd
http://www.tandf.co.uk/journals
corresponding two regime model in terms of their respect-
ive ability to account for the historical business cycle phase
change pattern evident in the data.
In the next section the particular regime-switching model
used in the analysis is outlined while the third section
contains the results. Brief conclusions follow in the fourth
section.
I I . TH E R E G I M E- S WI T C H I N G MOD E L
In a series of important papers, Hamilton (1989, 1990,
1991) elaborated upon theoretical aspects of his markov-
ian, regime-switching, approach to modelling time series
dynamics and demonstrated its use in a number of applica-
tions. In simple terms, a time series is conceived of being in
one of a number of di€ erent states or regimes at each point
in time. The likelihood of observing various values of the
series then depends upon the particular regime in which the
1133
 1134
series is, along with a speci® ed probability rule associated
with that regime.
In the context of the business cycle it is natural to dichot-
omize between two regimes, viz. contractions and expan-
sions in economic activity and this has been the maintained
hypothesis for most of the business cycle-related applica-
tions of this framework to date. For each regime the
simplest probability rule to govern the likelihood of
various observations is the normal density function with
di€ erent means and variances for contractions and expan-
sions. Hamilton also suggested the use of a Markov-type
probability rule to govern the likelihood of switching from
one regime into the other. The simplest such rule is that the
switching probability depends only on the current period
regime (rather than several earlier periods), and remains
constant regardless of the length of time the series has
been in a particular regime. The maintained model
employed here embodies this simple structure except the
issue of whether the most appropriate number of regimes
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A. P. L ayton and D. Smith
To obtain estimates of the parameter vector ‰u1 ;u2 ;u3 ;
0
¼1 ;¼2 ;¼3 ; p11 ;p12 ;p21 ;p22 ;p31 ;p32 Š constrained maximum
likelihood estimation (MLE) is used. The log-likelihood
for each of the various models was calculated using the
recursive algorithm proposed by Hamilton (1989). The
requirements for calculating this are the data and some
value for the parameter vector which falls within the allow-
able parameter space. The log-likelihood was then maxi-
mized using a constrained maximization technique which
uses numerically evaluated derivatives and the Broyden,
Fletcher, Goldfarb and Shanno quasi-Newton maximiza-
tion method (see Grace, 1994). To ensure that rapid con-
vergence to a maximum is achieved, a constrained
optimization technique was applied which required all
transition probabilities to be within the unit interval, and
all variances to be strictly positive. The constraints were
imposed using the sequential quadratic programming
method discussed in Grace (1994). All calculations were
performed using the Optimization toolbox of Matlab ver-

is two or three is left open for the time being. sion 5 in a unix-based operating system. The estimation
Let Y t and S t denote the growth rate and regime state in technique is started using a guess of the parameters. To
period t. Then: ensure that the resulting parameter estimates represent a
" # global rather than a local maxima, several alternative sets
2
1 ¡1 Y t ¡ ·i
 exp
f …Y t =S tˆi† ˆ p
2º¼i 2
… ¼i
† of starting values were tried.

where i ˆ 1;2;3 and 1 denotes a contraction phase, 2

denotes a slow growth expansionar y phase, and 3 denotes I I I . T H E E MPIR I C A L R E S U L T S
a fast growth expansionary phase, and P …S t ˆ 1 =S t¡1 ˆ
1† ˆ p11 ; P …S t ˆ 2 =S t¡1 ˆ 1† ˆ p12 ; P …S t ˆ3 =S t¡1 ˆ 1† ˆ Basic data for this analysis consist of monthly observations
p13 ˆ 1 ¡ …p11 ‡ p12 †; P…S t ˆ 1=S t¡1 ˆ 2† ˆ p21 ; P …S t ˆ 2= from 2/1950 to 11/1994 on the ECRI coincident index.
S t¡1 ˆ 2† ˆ p22 ; P…S t ˆ 3=S t¡1 ˆ 2† ˆ p23 ˆ 1 ¡ …p21 ‡ p22†; Quarterly, constant price, GDP data covering the same
P …S t ˆ 1 =S t¡1 ˆ 3† ˆ p31 ; P …S tˆ2 =S t¡1 ˆ 3† ˆ p32 and period are also used to enable a more direct comparison
P …S t ˆ 3 =S t¡1 ˆ 3† ˆ p33 ˆ 1 ¡ …p31 ‡ p32†. It should be with the work of Sichel (1994). Components of the coin-
noted that this three phase characterization allows for the cident index are reported in Table 1. 1 This series is pre-
discovery of some potentially very interesting business ferred for the current analysis since it has been found to
cycle dynamics. In particular, not only are three distinct have a turning point chronology (as determined by, for
phases allowed for, but switches among all three regimes example, the Bry± Boschan (1971) method) which is
are allowed. Thus, for example, not only is a switch from a remarkably close to that of the o cial NBER-determined
contractionary phase into a rapid growth recovery phase US business cycle chronology. This chronology is pre-
allowed (as conceived in Sichel (1994)), but the economy sented in Table 2. A monthly (quarterly) growth rate series
could also switch into a slow growth recovery and then into for the coincident index (GDP) is then used in the mod-
a rapid growth state (as in the most recent recovery for elling which follows. 2
instance). While more will be said on these potentially Two versions of the regime switching model as described
interesting dynamics later, this characterization is clearly above are estimated for the two series in question, viz. a
somewhat broader than Sichel’s characterization. two regime version and a three regime version. The two
1
ECRI (Economic Cycle Research Institute was founded by Dr Geo€ rey H. Moore and is based in New York) routinely adjusts the
trend of their computed indexes so that the series trend re¯ ects the trend in some commonly-known, relevant, published economic series.
For example, the coincident index is adjusted to have a long term trend similar to that of US GDP. However, this procedure also
occasionally shifts the turning point dates of the series and it was the unadjusted index which was found here to have turning points
closer to the o cial business cycle chronology. Therefore, it is the index without trend adjustment which is used in this analysis.
2
In traditional business cycle analysis an important part of the determination of turning points (phase changes) is the calculation of a
series MCD (standing for `months for cyclical dominance’ ). Essentially the MCD is the span of moving average required to produce a
smoothed series in which the cyclical component of the series dominates the irregular component. The MCD of ECRI’s coincident index
was 1. In practical terms this means that no prior smoothing of the index is required before taking growth rates. Growth rates were
calculated (for both the coincident index and GDP) as period-to-period changes expressed as percentage changes.
 US business cycle 1135
Table 1. Coincident index components Table 4. Model speci® cation tests of two state Markov-regime
switching model of di€ erent measures of the US business cycle ±
Personal Income (real) monthly coincident index and quarterly gross domestic product
GDP (real)
Industrial Production Coincident
Manufacturing and Trade Sales Speci® cation test index GDP
Employees in Non-Farm Sector
Unemployment rate (inverted) NTW test for 43.8510 14.0017
Autocorrelation …À2 …4†† (0.0000) (0.0073)
Note: Quarterly series like GDP are interpolated by ECRI to NTW test for 11.7199 2.7055
produce monthly data for incorporation in the indexes. ARCH …À2 …4†† (0.0196) (0.6083)
NTW test for ® rst order Markov 20.9765 6.6923
Table 2. T he US business cycle chronology assumption …À2 …4†† (0.0003) (0.1531)
Lagrange Multiplier test for 22.7601 6.6670
Coincident index Autocorrelation to lag 1 …À2 …1†† (0.0000) (0.0098)
Business cycle chronology chronology using BB1 Lagrange Multiplier test for 45.3701 6.1608
Autocorrelation to lag 2 …À2 …2†† (0.0000) (0.0459)
Peaks Troughs Peaks Troughs Lagrange Multiplier test for 44.4633 6.2102
Autocorrelation to lag 3 …À2 …3†† (0.0000) (0.1018)
7/53 5/54 7/53 5/54 Lagrange Multiplier test for 45.0297 6.8094
8/57 4/58 3/57 4/58 Autocorrelation to lag 4 …À2 …4†† (0.0000) (0.1463)
4/60 2/61 2/60 2/61 Lagrange Multiplier test for 21.8810 0.6010
12/69 11/70 10/69 11/70
Autocorrelation within state 1 …À2 …1†† (0.0000) (0.4382)
11/73 3/75 11/73 3/75
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1/80 7/80 1/80 6/80 Lagrange Multiplier test for 13.8632 6.4046
7/81 11/82 7/81 12/82 Autocorrelation within state 2 …À2 …1†† (0.0002) (0.0114)
7/90 3/91 6/90 3/91 Lagrange Multiplier test for 31.2413 0.9454
Autocorrelation at lag 2 …À2 …1†† (0.0000) (0.3310)
Notes: Lagrange Multiplier test for 8.0325 0.7246
Median phase length: expansions ˆ 39 months Autocorrelation at lag 3 …À2 …1†† (0.0046) (0.3946)
Contractions ˆ 10 months Lagrange Multiplier test for 23.5137 1.4080
1
By Bry± Boschan (1971) turning point method. Autocorrelation at lag 4 …À2 …1†† (0.0000) (0.2354)
Lagrange Multiplier test for 6.0776 0.6882
Table 3. Parameter estimates of two state Markov-regime switch- ARCH to lag 1 …À2 …1†† (0.0137) (0.4068)
ing model of di€ erent measures of the US business cycle ± monthly Lagrange Multiplier test for 10.3543 2.1089
coincident index and quarterly gross domestic product ARCH to lag 2 …À2 …2†† (0.0056) (0.3484)
Lagrange Multiplier test for 10.4403 3.3326
Parameter Coincident index GDP ARCH to lag 3 …À2 …3†† (0.0152) (0.3431)
Lagrange Multiplier test for 15.4057 4.2069
p11 0.8779 0.7691 ARCH to lag 4 …À2 …4†† (0.0039) (0.3787)
(0.0282) (0.0850)
p12 7110.1221 710.2309 Notes: Two di€ erent model speci® cation tests are conducted
p21 7110.0305 710.0857 (Newey± Tauchen± White dynamic speci® cation test, and
p22 7110.9695 710.9143 Lagrange Multiplier tests) for Autocorrelation and ARCH e€ ects
(0.0079) (0.0305) of varying lags, and the NTW test for the validity of the ® rst order
·1 70.5466 70.1287 Markov assumption. Asymptotic p-values are in parentheses.
(0.1012) (0.2719)
·2 7110.6339 711.1678
(0.0329) (0.1144) presence of residual ARCH and autoregressive (AR) char-
¼21 7110.4455 710.8430
(0.0695) (0.1815)
acteristics in the coincident index data which are not being
¼22 7110.3389 710.6710 captured by the two regime model. In the case of the GDP
(0.0421) (0.1017) data only autocorrelation seems to be a problem.
Log-likelihood 7547.7870 7246.7889 Parameter estimates for the three regime model for each
Note: Robust standard errors are in parentheses and are calcu- series are presented in Table 5, with diagnostic checks for
lated using a numerically evaluated Hessian and score. ARCH and AR characteristics supplied in Table 6.
Interestingly, increasing the number of regimes has changed
regime version’s parameter estimates are presented in Table the diagnostic picture quite considerably. The three regime
3. To check the adequacy of the dynamic structure of these model for GDP appears to be quite adequate with no need
models, Hamilton’s (1996) diagnostic tests for autoregres- for any further dynamic structure beyond that captured by
sive conditional heteroscedasticity (ARCH) and autocorre- the three regime Markov structure itself. This then poten-
lation are presented in Table 4. 3 These tests suggest the tially provides an alternative model speci® cation for GDP

3
Some brief details of the diagnostic tests are provided in the Appendix. The interested reader is referred to Hamilton (1996 ) for a fuller
discussion.
 1136 A. P. L ayton and D. Smith
Table 5. Parameter estimates of three state Markov-regime replicating the quarterly value for each of the relevant
switching model of di€ erent measures of the US business cycle ± three months.
monthly coincident index and quarterly gross domestic product
Parameter estimates for the three regime model incor-
Coincident index porating an AR(2) structure are also presented in Table 5
with relevant diagnostics detailed in Table 6. As is evident
Parameter AR(0) AR (2) GDP
from Table 6 this model is now acceptable in terms of its
p11 0.8730 0.6703 0.7799 ability to capture the dynamic characteristics of the data on
(0.0305) (0.0872) (0.0722) the coincident index. Furthermore, the two AR parameter
p12 0.0286 0.2211 0.0310 estimates are statistically signi® cant and the overall model,
(0.0379) (0.0845) (0.0323)
p13 0.0984 0.1086 0.1891 in terms of the value of its log-likelihood, apparently is a
(0.0345) (0.0592) (0.0789) statistically better representation of the data than the
p21 0.0387 0.0293 0.0792 model without the AR structure.
(0.0136) (0.0128) (0.0413)
p22 0.9376 0.9478 0.8128
However, in determining the preferred model for the
(0.0188) (0.0174) (0.0652) coincident index, another important consideration is the
p23 0.0237 0.0229 0.1081 degree of closeness between the model-generated regime
(0.0172) (0.0154) (0.0536) probabilities and the `true’ regime probabilities as deter-
p31 0.0214 0.0598 0.0826
(0.0186) (0.0041) (0.0595) mined by the NBER chronology. After all, the major moti-
p32 0.1047 0.5635 0.2274 vation for constructing and analysing the coincident index
(0.0365) (0.1076) (0.0856) is the belief that it is a reasonable proxy for the business
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p33 0.8740 0.3767 0.6900 cycle. A very important criterion, therefore, in evaluating
(0.0367) (0.1086) (0.0764)
·1 70.5515 70.9456 70.1684 any model which is developed to represent the underlying
(0.0906) (0.2304) (0.2147) data-generatin g mechanism (DGM) for the coincident
·2 0.4324 0.4182 0.6860 index is the consistency of the implied regime probabilities
(0.0373) (0.0721) (0.0544) with the o cial business cycle chronology for the USA.
·3 1.0660 1.5517 1.8374
(0.0960) (0.1884) (0.1410) To evaluate this, the so-called quadratic probability
¼21 0.4467 0.4618 0.8872 score (QPS) is used. The QPS was suggested by Diebold
(0.0702) (0.1366) (0.2274) and Rudebusch (1989) and has been used by Layton (1997)
¼22 0.1366 0.1819 0.1537 in earlier related work. The QPS is de® ned as follows
(0.0170) (0.0248) (0.0315)
¼23 0.4612 0.6184 0.5104 T
1 X
(0.1072) (0.2356) (0.1719) QPS ˆ ¤ …Pt ¡ D t†2
¿1 ± 0.2801 ± T tˆ1
(0.0607)
¿2 ± 0.3891 ± where Pt denotes the model-derived probability of a con-
(0.0680) tractionary phase and D t is a binary variable taking the
Log-likehood 7485.6202 7452.2396 7229.7423
value of 1 during a contractionary phase and zero other-
Notes: wise as de® ned by the o cial business phase chronology of
1. Robust standard errors are in parentheses and are calculated Table 2. The closer is QPS to zero the more consistent are
using a numerically evaluated Hessian and score. the model-generate d regime probabilities with the o cial
2. The AR (2) speci® cation was as follows: yt ¡ ·i;t ˆ
¿1 …yt¡1 ¡ ·i;t¡1† ‡ ¿2 …yt¡2 ¡ ·i;t¡2† ‡ "it .
business cycle chronology.
In addition, a slight variation on this statistic is also
calculated, viz. the mean absolute probability score
as compared to that used by Hamilton (1989). On the other (MAPS). This is de® ned simply as:
hand, the diagnostics for the coincident index continue to 1 XT
suggest the dynamic structure captured by the three regime MAPS ˆ ¤ jP ¡ D t j
T tˆ1 t
markov structure is an inadequate characterization of the
dynamic properties of the data for that series. Again, the closer is MAPS to zero the more consistent are
To investigate this further, rather than incorporate the model-generate d regime probabilities with the o cial
simultaneously both ARCH and (AR) characteristics into business cycle chronology.
the three regime model for the coincident index, an AR In Table 7 the QPS and MAPS statistics for the 2 regime
structure is ® rst incorporated to see if this impacts at all model and the 3 regime model ± with and without AR
on the ARCH diagnostics. The Lagrange multiplier tests structure ± are presented.
for autocorrelation suggested an AR(2) structure would be The ® rst point to note is that there is essentially no dif-
most appropriate . Parenthetically, this may not be too sur- ference in performance between the two regime model and
prising given that two of the six index components are the simple three regime model. This is as expected since the
actually quarterly but converted to monthly by simply third state is used to distinguish between expansionary
 US business cycle 1137
Table 6. Model speci® cation tests of three state Markov-regime switching model of di€ erent measures of
the US business cycle ± monthly coincident index and quarterly gross domestic product

Coincident index

Speci® cation text AR(0) 1 AR(2) 2 GDP1

NTW test for 24.1478 16.5929 6.1980

Autocorrelation …À2 …9†† (0.0041) (0.0555) (0.7200)
NTW test for 30.0583 11.0227 10.3375
ARCH …À2 …9†† (0.0004) (0.2742) (0.3239)
NTW test for ® rst order Markov 7.0276 9.7063 7.6207
assumption …À2 …6†† (0.3183) (0.1376) (0.2672)
Lagrange Multiplier test for 6.0638 ± 0.7702
Autocorrelation to lag 1 …À2 …1†† (0.0138) (0.3802)
Lagrange Multiplier test for 26.1134 ± 3.0043
Autocorrelation to lag 2 …À2 …2†† (0.0000) (0.2226)
Lagrange Multiplier test for 27.6072 ± 3.5327
Autocorrelation to lag 3 …À2 …3†† (0.0000) (0.3165)
Lagrange Multiplier test for 27.6072 ± 0.7826
Autocorrelation within state 1 …À2 …1† (0.0000) (0.3763)
Lagrange Multiplier test for 0.0315 ± 2.2643
Autocorrelation within state 2 …À2 …1†† (0.8590) (0.1324)
Lagrange Multiplier test for 1.7400 ± 1.9259
Autocorrelation within state 3 …À2 …1††
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(0.1871) (0.1652)
Lagrange Multiplier test for 19.4154 ± 2.3343
Autocorrelation at lag 2 …À2 …1†† (0.0000) (0.1265)
Lagrange Multiplier test for 2.9374 ± 1.1039
Autocorrelation at lag 3 …À2 …1†† (0.0866) (0.2934)
Lagrange Multiplier test for 9.7022 ± 3.7831
ARCH to lag 1 …À2 …1†† (0.0018) (0.0518)
Lagrange Multiplier test for 10.2856 ± 5.5038
ARCH to lag 2 …À2 …2†† (0.0058) (0.0638)
Lagrange Multiplier test for 11.6416 ± 7.9684
ARCH to lag 3 …À2 …3†† (0.0087) (0.0467)

Notes:
1
Asymptotic p-values in parentheses. Two di€ erent model speci® cation tests are conducted (Newey±
Tauchen± White dynamic speci® cation test, and Lagrange Multiplier tests) for Autocorrelation and
ARCH e€ ects of varying lags, and the NTW test for the validity of the ® rst order Markov assumption.
2
Only the NTW tests were calculated for the AR(2) three state model because the LM tests are compu-
tationally unwieldy for such a model. For example, calculating a third order LM test requires keeping
track of 36 or 729 di€ erent sequences of states at each point in time.

phases and provides little additional insight into the timing
of contractions. The second, and more important point
relates to the relative performance of the three regime
model with AR structure. It clearly performs signi® cantly
worse than the simpler three regime model with no AR
structure (as well as the two regime model).
The reason for this may be that the addition of AR
structure ± by virtue of adding a further degree of persis-
tence to the process assumed to be the DGM for the data ±
increases the estimated probability that the series will con-
tinue to be forecast to be in whatever is the current regime
for any given data point. Around turning points then, in
comparison to the model without AR structure, the addi-
tion of the AR component may produce higher estimated
probabilities that the turning point has not yet occurred for
several periods after it actually has occurred.
Hence, for the purpose of identifying turning points, it
may well be that the simple markov characteristic, without
any further AR structure, provides the most appropriate
dynamic representation . Therefore, given that the simple
three regime model without AR structure provides the
closer correspondence to the o cial business cycle chron-
ology, it is this model which is considered the more pre-
ferred model here.
Returning now to the parameter estimates of Tables 3
and 5, whilst there is great di culty in formally testing a
three regime model against a two regime version (because
the usual likelihood ratio type test statistic is nonstandard) ,
nonetheless the sample log-likelihood for each series is
reduced quite dramatically (particularly for the coincident
index) when the number of regimes is restricted to two as
compared to the three regime model. Parameter estimates
are also, in the main, consistent with prior expectations.
Thus, within the framework of this paper, the sample evi-
dence would seem to support quite strongly the notion of a
clearly distinguishable three phase cycle characterized by a
 1138 A. P. L ayton and D. Smith
Table 7. T he performance of various Markov switching models of point estimates of Table 5. The ® rst point derives from
the US coincident index using QPS and MAPS the relative magnitudes of the regime variances, viz.
Probability used 2 State 3 State 3 State AR(2) 1. For both GDP and the coincident index the volatility of
Panel A: QPS growth is more than twice as great in either the contrac-
Forecast (1) 0.0527 0.0531 0.1111 tionary phase or the fast growth expansionary phase than it
Filter (2) 0.0308 0.0342 0.1038 is in the slow growth expansionary phase. While the di€ er-
Smoothed (3) 0.0319 0.0348 0.1045
ences are clearly quite large, formal t-tests con® rm they are
Panel B: MAPS also statistically signi® cant. Thus, as has been found by
Forecast (1) 0.1294 0.1286 0.1702
Filter (2) 0.0759 0.0731 0.1363 others, the economic growth cycle is not characterized by
Smoothed (3) 0.0619 0.0594 0.1319 variance stationarity but is clearly regime-dependent. 5
Notes: Now, concentrating on the regime-switching transition par-
1. Forecast based on data to period t ¡ 1. ameter point estimates associated with the coincident
2. Forecast based on data to period t. index, 6 ® ve implications arise from their relative magni-
3. Forecase based on data to period T .
tudes, viz.
2. Given the economy is in a contractionary phase (regime
1), the model’s point estimates suggest it is about three
contractionary phase, a slow growth expansionary phase times as likely (obtained as the ratio 0.0984/0.0286 ) for
and a fast growth expansionary phase. 4 the economy to switch into the `high growth recovery-
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Of interest are the estimates of mean growth rates in
normal and fast growth expansionary phases. For example,
using the GDP series and Table 5, estimated average
annual growth in the normal expansion phase is 2.8%.
Mean growth in fast-growth expansion phases is, on the
other hand, 7.5%. Whilst this is obviously very fast, the US
economy has probably only been in such rapid growth
expansionary phases for about nine years out of the 45
year period under study (see Table 9 for further details).
It should also be remembered that one entire post-war US
expansion (11/49± 7/53) actually had an overall measured
mean growth rate of 6.4% so that 7.5% average growth for
the fast growth phase ± usually quite short in duration ±
may not be too unrealistic.
In passing, it should also be pointed out that these mean
growth rate estimates are quite consistent with the esti-
mated mean expansionary growth rate for GDP listed in
Table 3 using the two-phase model (the latter estimate
being roughly a weighted average of the estimates in
Table 5). This mean growth rate of 4.7% (annualized) is
quite consistent with the actual measured average annual
growth rate of expansions of about 4.3%. This growth rate
is the average over all post-war expansions as determined
by the NBER chronology.
Now using the three phase characterization, a good deal
can be inferred about business cycle dynamics from the
type’ phase than into the `slower expansion-type ’ phase.
In fact, a comparison of the estimate of p12 with its asymp-
totic, robust standard error, suggests there is some doubt as
to whether the estimate is statistically signi® cantly di€ erent
from zero. 7 At the very least then, the estimates suggest it is
much more likely for the economy to enter into a fast
growth phase out of a recession. While this provides an
alternative type of evidence in support of Sichel’s argu-
ment, the current approach goes further and explicitly
allows for the economy to switch into either type of expan-
sionary phase from a contraction and actually provides an
estimated relative probability for each possibility. While
the estimates support the notion that it is much more likely
to witness a fast growth phase following a contraction it
nonetheless may be possible to witness a move into a slow
growth expansion phase. As noted above, the most recent
recovery out of recession is an example of this very type of
transition.
3. Given the economy is in a fast expansionary growth
phase (regime 3), the model’s estimates suggest it is evi-
dently relatively unlikely for it to switch immediately into
a contractionar y phase. In fact, the probability of this kind
of a transition (0.0214) is the smallest of all transition
probabilities and may well be insigni® cantly di€ erent
from zero when compared with its estimated standard
error. 8 Rather, it is much more likely for the economy to

4
One puzzling caveat with the results for GDP is the apparently statistically insigni® cant parameter estimate for the contractionary phase
mean growth rate (less so in three phase version).
5
See, for example, French and Sichel (1993) . In the case of the coincident index, Wald tests of the hypotheses ¼21 ˆ ¼22 , ¼21 ˆ ¼23 , ¼22 ˆ ¼23
produced test statistics of 18.3390, 0.0118, 9.6156 respectively. These are each distributed as À2 (1).
6
Whilst the discussion will focus on the coincident index, a similar qualitative story applies to GDP unless otherwise indicated in the text.
7
Note, however, that its standard error is estimated at 0.0288 when calculated using the Hessian matrix of the parameter estimates and is
estimated at 0.0234 when computed using the outer product approach. Thus there is some uncertainty surrounding the associated t-
statistic.
8
A similar argument as outlined in Footnote 7 applies here also.
 US business cycle
® rst go into a phase of slower growth (regime 2). Indeed, it
is about ® ve times as likely for the economy to go from a
high growth phase into the slower growth phase than into a
contractionary phase (0.1047/0.0214).
4. It is interesting to note the picture which is suggested by
the transition parameter estimates given the economy is in
a slower expansionary phase. Those for the monthly coin-
cident index suggest it is somewhat more likely for the
economy to switch into a recession than to switch into
another phase of fast growth (0.0387/0.0237) . The esti-
mated standard errors are such, however, as to result in
the di€ erence testing as statistically insigni® cant.
The point estimates for GDP, on the other hand, suggest
it is more likely for the economy to switch from a slow
growth phase back into a fast growth phase rather than
go into a recession (0.1081/0.0792). Again, however, the
estimated standard errors are such as to result in the dif-
ference testing as statistically insigni® cant.
A reasonable, conservative conclusion to draw from
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these estimates is that, once the economy is in a slow
growth phase, it is probably about as likely to slip into a
recession as it is to transition back into a fast growth phase.
However, importantly, by taking this aspect of the esti-
mates in conjunction with the discussion of point 3, the
picture suggested by the estimates is that the economy is
most likely to move into a recession after ® rst transitioning
from a fast growth phase into a slow growth phase (see
below also). 9
5. The model estimates suggest it is almost twice as likely
for the economy to switch into the contractionar y phase of
the cycle from the slow growth expansionary phase as it is
to switch directly into contraction from the fast growth
phase (0.0387/0.0214) . This is consistent with the other
estimated transition probabilities discussed above. 10
6. Finally, once in a fast growth phase, the estimates sug-
gest there is a probability of about 0.98 (0:8740 ‡ 0:1047)
that the economy will not transition straight into a reces-
coincident index
sion in the next period. Similarly, once in a slow growth
expansion, there is nonetheless still a high probability of
about 0.96 (slightly smaller than for the fast growth case)
that the economy will not transition straight into a reces-
sion in the next period. These large probabilities are, of
course, nothing more than the statistical re¯ ection of the
much longer periods of expansion compared with contrac-
tions evident in the historical record. During any long-lived
expansion there are likely to be extended periods of both
types of expansionary phases and the distinct possibility of
switching back and forth between them rather than switch-
ing into contraction.
9
For further on this aspect of the nature of the transition into recession the reader is referred to Gordon (1979).
10
However, in the case of GDP, the corresponding estimated transition probabilities are not statistically signi® cantly di€ erent.
1139
These estimated regime-switching transition probabilities
can therefore be interpreted as suggesting the following
`most likely’ or `stylized’ business cycle characterization,
viz. a relatively short contraction phase followed by a fast
growth recovery phase, giving rise to a slower expansionary
phase ± sometimes interrupted occasionally by fast growth
phases ± but eventually resulting in a ® nal slow growth
phase which leads to the next contractionary phase.
While this would be the stylized characterization, the prob-
abilistic nature of the framework nonetheless allows for
individual cycles to be quite unique and vary quite substan-
tially from this `most likely’ scenario. Of course, all of this
would probably come as little surprise to business cycle
analysts and is entirely consistent with what has been
observed in practice in the business cycle historical record.
However, what the three phase probabilistic regime-
switching framework allows is an interesting, alternative
approach to identifying and quantifying these business
cycle dynamics.
Furthermore, as each cycle is unique and is potentially
impacted di€ erently by the macroeconomic policies pur-
sued by the authorities at the time, it may be instructive
to compare the economic circumstances surrounding two
recent US economic recoveries, viz. the 1982 and 1991
recoveries. Both of these recoveries gave rise to long expan-
sions but, as can be seen from Table 9, the ’82 recovery was
of the `fast’ variety whereas the ’91 recovery was of the
`normal’ or `slow’ variety. This di€ erence in the speed of
recovery is also evident from Fig. 1 which provides a
graphical representation of ¯ uctuations in growth rates of
the coincident index. Furthermore, the macroeconomic cir-
cumstances and policy in¯ uences were quite di€ erent
between these two episodes.
4
% change of
0
-4
50 55 60 65 70 75 80 85 90 year
Fig. 1. Plot of month-to-month growth rates in ECRI’s coincident
index. Shaded areas correspond to o cial US recessions as deter-
mined by the NBER dating panel.
 1140
In 1982, the US economy had just come out of a long,
and quite severe, recession which itself had followed only a
very brief 12 month period of expansion from the previous
recession. The ® rst of these 1980s recessions (1/1980±
7/1980) was certainly partially the result of the second oil
crisis while the duration and severity of the second
(7/1981 ± 11/1982) was undoubtedly the result of the cumu-
lative e€ ect of the very tight monetary policy pursued at
the time by the FED in its e€ ort to bring down the double
digit US in¯ ation of the late 1970s and early 1980s.
By contrast, the 1991 recovery followed quite a short
recession (7/1990± 3/1991) which was also quite mild com-
pared to the 1981/82 recession. Similarly, in terms of policy
considerations , this most recent recession did not follow a
severe monetary policy tightening, as was the case in 1981/
82. The macroeconomic events and policy responses lead-
ing up to this recession were as follows. The 1987 stock-
market crash led the FED to immediately ease monetary
policy. However, this easing was quickly reversed as it
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became clear the potential for further ® nancial market
crises had been averted. A series of tightenings then fol-
lowed throughout 1988 and into early 1989.
However, evidence of an economic growth slowdown in
early 1989 again led the FED to begin easing interest rates
later in that year. Thus monetary policy settings were eased
during the year preceeding the onset of the 1990/91 reces-
sion. This pre-emptive easing undoubtedly contributed
signi® cantly to the more moderate nature of the 1990s
100%
80%
60%
40%
20%
0%
Fig. 2. Plot of smooth probability of recession ± 2 phase model
A. P. L ayton and D. Smith
recession in comparison to that of the 1980s. As it turned
out, the 1991 recovery, quite possibly largely because of the
moderate nature of the previous recession, was quite anae-
mic with low rates of growth ± particularly employment
growth ± for the ® rst couple of years into the current
long expansion.
It should be noted that Sichel (1994) indicated he had
had personal correspondence from James Hamilton in
which Hamilton had advised he had estimated a three
regime Markov model for GNP. Evidently the parameter
estimates obtained by Hamilton (unreported by Sichel)
were such as to suggest a similar stylized characterization
as outlined above. Sichel apparently also used Hamilton’s
three phase model and concluded (without reporting the
actual results): `the three phase Markov model is not espe-
cially informative about the particular pattern of three
phases in [his] sample’ (p. 272). The current results would
seem to be rather contrary to this conclusion reached by
Sichel.
As suggested by a referee, the model-generated probabil-
ities of a contraction for each coincident index data point
are provided in Figs 2 and 3. As might be expected, and as
mentioned earlier, since the third phase is adding clarity to
understanding further the nature of the expansionary phase
rather than the contractionary phase, there is little di€ er-
ence between these two ® gures.
Also included in Table 8 is a comparison between the
o cial US business cycle chronology and model-generated
 US business cycle 1141
100%

80%

60%

40%

20%
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0%

Fig. 3. Plot of smoothed probability of recession ± 3 phase model

Table 8. Business cycle chronology and model-derived turning However, of more interest is the information on regime
point dates switches between the two types of expansions using the
Peak Trough
coincident index. This is provided in Table 9. By way of
explanation, given the economy was not in a contraction
Actual Model Actual Model (as determined above), the dates selected in Table 9 were
2 State model based upon the occurrence of a run of at least three con-
7/53 6/53 5/54 5/54 secutive months (i.e. one quarter) in which one type of
8/57 3/57 4/58 4/58 expansion was relatively more likely than the other.
4/60 2/60 2/61 1/61
12/69 11/69 11/70 11/70 Whilst this may be regarded as rough and ad hoc some
11/73 11/73 3/75 3/75 aspects of Table 9 are worth a mention in the context of
1/80 1/80 7/80 6/80 the earlier discussion of the transition probability esti-
7/81 7/81 11/82 11/82
7/90 6/90 3/91 3/91 mates.
First, of the eight expansions covered, this analysis sug-
3 State model
7/53 7/53 5/54 5/54 gests the economy went into a fast growth recovery phase
8/57 3/57 4/58 4/58 on ® ve occasions. On a sixth occasion (the 12/70± 11/73
4/60 2/60 2/61 2/61 expansion) the ® rst two months growth in the expansion
12/69 11/69 11/70 11/70
11/73 11/73 3/75 3/75 were nonetheless strong and were clearly inferred by the
1/80 1/80 7/80 7/80 model to be associated with the fast growth phase. Second,
7/81 7/81 11/82 12/82 on all occasions bar one, the economy transitioned into a
7/90 6/90 3/91 3/91
® nal slow growth phase before transitioning into a contrac-
Note: Model dates are selected as in Layton (1996). tion. Third, expansions are typically characterized by at
least one switch between the two types of expansions.
chronologies for the coincident index. These chronologies
were determined as in Layton (1996), viz. peaks (troughs)
were recognized if a subsequent run of at least ® ve conse- I V . BR I E F C ON C L U S I ON S
cutive data point probabilities greater (less) than 0.5 were
observed. This rule is analogous to a minimum phase length In this paper a three phase version of Hamilton’s regime-
of ® ve months used by the NBER. Again, there is little switching model has been employed to further investigate
di€ erence between the two regime and three regime models. the notion that the US business cycle is more accurately
 1142 A. P. L ayton and D. Smith
Table 9. An estimated chronology of US fast and slow (or normal) interpreted to cast into relief several important and inter-
expansionary phases esting features of what could be called a `stylized’ US busi-
Model determined Expansion ness cycle, viz. a relatively short contraction phase leading
expansion dates1 type End date Duration2 to a fast growth recovery phase, followed by a slow expan-
sionary phase interrupted occasionally by fast growth
6/54 ± 3/57 Normal 8/54 3
(6/54 ± 8/57) Fast 9/55 13 phases, but eventually resulting in a slow growth phase
Normal 7/56 10 which gives rise to the next contractionar y phase. While
Fast 10/56 3 this would be the stylized characterization, the probabilistic
Normal 3/57 5 nature of the framework nonetheless allows for individual
5/58 ± 2/60 Fast 2/60 24
(5/58± 4/60) cycles to be quite unique and to vary quite substantially
3/61 ± 11/69 Fast 12/61 10 from this `most likely’ scenario. 11
(3/61± 12/69) Normal 9/64 33
Fast 2/66 17
Normal 11/69 45
12/70± 11/73 Normal 11/71 12 R EFER ENCES
(12/70 ± 11/73) Fast 2/73 15
Normal 11/73 9 Boldin, M. D. (1990) Characterising business cycles with a
4/75 ± 1/80 Fast 2/76 11 Markov switching model: evidence of multiple equilibria.
(4/75± 1/80) Normal 1/78 23 W orking paper, Federal Reserve Bank of New York.
Fast 5/78 4 Bry, G. and Boschan, C. (1971) Cyclical Analysis of Time Series:
Normal 1/80 20 Selected Procedures and Computer Program s, Technical
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8/80 ± 7/81 Fast 11/80 4 Paper 20, NBER, Columbia University Press.
(8/80± 7/81) Normal 7/81 8 Burns, A. and Mitchell, W. (1946 ) Measuring Business Cycles,
1/83 ± 6/90 Fast 2/84 14 National Bureau of Research, New York.
(12/82 ± 7/90) Normal 6/90 76 Cai, J. (1994) A Markov model of unconditional variance in
4/91 ± Normal ± 44+ ARCH, Journal of Business and Economic Statistics, 12,
(4/91± )
309 ± 27.
Notes: Diebold, F. X. and Rudebusch, G. D. (1989) Scoring the leading
1
Corresponding O cial NBER expansion dates are in paren- indicators, Journal of Business, 62, 369 ± 91.
theses. French, M. V. and Sichel, D. E. (1993) Cyclical patterns in the
2
According to the model, the total number of months of expan- variance of economic activity, Journal of Business and
sion during the period of study is 403, with 115 of these classi® ed Economic Statistics, 11, 113 ± 19.
as fast growth phase months. The other 135 months are classi® ed Gordon, R. (1979) The end-of-expansion phenomenon in short-
as contraction phase months. run productivity behaviour, Brookings Papers on Economic
Activity, No. 2.
Grace, A. (1994) Optimisation Toolbox User’s Guide (January):
MathWorks, Natick.
Hamilton, J. (1989) A new approach to the analysis of time series
conceived as having three, statistically distinguishable and the business cycle, Econometrica , 57, 357± 84.
phases as opposed to the more common (at least in the Hamilton, J. (1990) Long swings in the dollar: are they in the data
regime switching business cycle literature) alternative of a and do markets know it?, American Economic Review, 80,
689 ± 713.
two regime characterization. Using consistency with the Hamilton, J. (1991) A quasi-Bayesian approach to estimating par-
o cial business cycle chronology as an additional evalua- ameters for mixtures of normal distributions, Journal of
tive criterion to statistical goodness-of-® t, a three regime Business and Economic Statistics, 9, 27± 39.
model without any AR dynamics is found to be the pre- Hamilton, J. (1996 ) Speci® cation testing in Markov-switching
ferred model for the coincident index. It is argued that the time-series models, Journal of Econometrics, 70, 127 ± 57.
Layton, A. (1996 ) Dating and predicting phase changes in the US
AR dynamics in this case imply persistence beyond that business cycle, International Journal of Forecasting, 12, 417±
captured by the markovian dynamics which results in 28.
higher estimated probabilities that the series will continue Layton, A. (1997) Do leading indicators really predict Australian
to be forecast to be in whatever is the current regime for business cycle turning points?, T he Economic Record, 73,
any given data point. Such estimated probabilities may 258 ± 69.
Schultze, C. L. (1964) Short-run movements in income shares, in
signi® cantly lag the occurrence of actual turning points. T he Behaviour of Income Shares: Selected T heoretical and
Furthermore, the relative values of the estimated transi- Empirical Issues, Conference on Income and Wealth, Vol.
tion probabilities of the three regime model may be usefully 27, Princeton University Press, p. 143± 82.

11
As pointed out by a referee, a more comprehensive analysis of business cycle dynamics would track the dynamics of labour, product
and ® nancial markets over the cycle and seek to shed light on the informational content present in leading indicators during the cycle.
Whilst this is undoubtedly true, the focus of the present paper was to extend the work of Sichel (1994) and to determine the usefulness of
employing the three phase characterization of the cycle as opposed to the two phase characterization used in a number of other recent
papers. For an aspect of the leading indicator dimension, readers are referred to Layton (1997).
 US business cycle
Sichel, D. E. (1994) Inventories and the three phases of the busi-
ness cycle, Journal of Business and Economic Statistics, 12,
269 ± 77.
A PPE N D I X : MOD E L S PE C I F I C A TI ON T E S T S
The tests for autocorrelation and ARCH e€ ects follow
closely the procedure suggested by Hamilton (1996). The
Newey, Tauchen and White (NTW) tests for ARCH, auto-
correlation, and the validity of the ® rst order Markov
assumption, as well as the Lagrange multiplier (LM) tests
for ® rst order autocorrelation within each regime and
across regimes were all calculated following Hamilton’s
approach. Our approach di€ ers from Hamilton’s in that
we use a numerically evaluated score vector, while
Hamilton calculates the score analytically. Furthermore,
the more usual approach, which others have used, only
uses the LM tests for ® rst order autocorrelation and
ARCH. However, our tests cater for up to fourth order
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dynamics in the two state models, and third order in the
three state models (note these limits are imposed to ensure
computational feasibility).
The LM tests for autocorrelation across regimes was
based on the following model:
r
X intercept is state dependent, however the other parameters
yt ¡ ·i ;t ˆ ¿j …yt¡j ¡ ·i ;t¡j † ‡ "it …A1†
jˆ1
where "it ¹ Nor …0;¼2i †:
Under the null of no autocorrelation, ¿1 ˆ ¢ ¢ ¢ ˆ ¿r ˆ 0
and Equation A1 simpli® es to the basic model which
simply has di€ erent means and variances in each state:
yt ˆ ·i;t ‡ "it …A2†
The LM test uses the score of Equation A1 evaluated
under the null hypothesis of no autocorrelation. This is
calculated fairly simply following Hamilton by taking the
score of the simple model Equation A2 and stacking
the derivatives of the log of the density with respect to
the autoregressive terms in Equation A1. The derivatives
are again calculated numerically. A similar procedure was
used to calculate the LM tests for autocorrelation at a par-
1143
ticular lag length, except the following alternative speci® ca-
tion was used
yt ¡ ·i ;t ˆ ¿j …yt¡j ¡ ·i;t¡j † ‡ "it …A3†
for j ˆ 1;. . . ;r. The score is again computed by stacking
the score of the simple model Equation A2 over the de-
rivatives of the log of the density with respect to the auto-
regressive parameters in Equation A3.
The LM tests for ARCH were calculated similarly to the
autocorrelation tests with the alternative model taking the
Markov switching model of Cai (1994) where the con-
ditional variance is given by:
r
X
¼2tji;j ˆ ¼2i ‡ ¬k "2t¡kjj …A4†
kˆ1
The conditioning on j occurs since a di€ erent error term
will result for each di€ erent assumed sequence of states.
Hamilton’s algorithm for calculating the log-likelihood
requires calculating the conditional densities at each
point in time and relevant sequences of states, in this case
2r‡1 , and then weighting by the probability of that
sequence occurring and summing over these weighted like-
lihoods. Note that the speci® cation in Equation A4 allows
the conditional variance to vary between states since the
are state invariant. Under the null hypothesis of no ARCH,
the intercept in Equation A4 will equal the conditional
variance calculated in model Equation A1. The score of
the ARCH model, estimated under the null of no
ARCH, is calculated in a similar fashion to the autocorre-
lation scores. This is done by calculating the derivative of
the log density with respect to the extra parameters
¬1 ;. . . ;¬r evaluated under the null of no ARCH, equiva-
lent to the restriction that ¬1 ˆ ¢ ¢ ¢ ˆ ¬r ˆ 0, and stacking
the score vector of the simple model over these new terms.
All the LM tests are then calculated using the score vec-
tor for the various alternative speci® cations, evaluated
under the null hypothesis that the model is correctly speci-
® ed. The test statistic is calculated as the uncentred coe -
cient of determination of a regression of the score vector on
one (see Hamilton, 1996).