Business and financial cycle across regimes: Does financial stress matter?

Identifying the business and financial cycles and their regimes is crucial for understanding the economy’s state and financial market dynamics. Using a bivariate four-regime Markov-switching framework, we assess the accuracy of a model that identifies the business cycle by combining financial and real variables and compare it to a model that only uses real variables. We find that a model that incorporates information from a financial stress index outperforms a model based solely on real variables, not only during a financial crisis, but also, and more interestingly, during economic downturns. The empirical evidence provides insights for policymakers and investors to improve economic policy formulation, investment strategies, strategic decision-making, and proactive risk management. The results are robust to various model specifications.