Journal of Econometrics 1 (1973) 3-16.

0 North-Holland Publishing Company

A MARKOV MODEL FOR SWITCHING REGRESSIONS*

Stephen M. GQLDFELD and Richard E. QUANDT

Princeton Lhiversity

1. Introduction

Consider a situation in which observations, indexed by i (i=l, .... n),

are available on a dependent variable yi and on k independent variables
Xri; ***)
Xki. Assume that the ith observation on y is generated by one or
the other of two’ true regression equations, i.e., either

Yi= ’
j= 1
PljXji+ &!li=X~P1 + Uli (1)

or

Yi = ,Fl fl2pji + U2i=XJp2 + U2i (2)

where pt and p2 are the vectors of the coefficients Prj, fl2j, where Xi is
the vector of the ith observation on the independent variables and
where Uri and U2i satisfy the classical assumptions made about error
terms and are, for convenience, assumed to be distributed as iV(0, u2)
2’
and N(0, ~2) respectively. If it is further assumed that (/3r, uf) # (p2, a2),
the regression system given by (1) and (2) may be thought to be switch-
ing between the two equations or ‘regimes’. This raises the question of

* We would like to thank Ray C. Fair for reading an earlier version of this paper. We grate-
fuRy acknowledge financial support from the National Science Foundation.
r Lt is only for simplicity’s sake that we confine our attention to the case of only two
generating equations. Although some of the algebraic details will differ if there are more than
two, there is no diffe :ence in principle.
4 SM. Goldfeld, R.E. Quandt, Switching regressions

estimating the parameters of (1) and (2) and of testing the null hypoth-
esis that (/3t, uf) = (&, ui).
It is crucial for what follows that the investigator is assumed to have
no definitive a priori knowledge about how to classify the data between
the two regimes. If he did have such knowledge the problem of testing
the null hypothesis is solved by the Chow-test (Chow, 1960). In the ab-
sence of such knowledge, the problem can be successfully attacked only
by imposing some further structure on it.
The simplest type of structure consists of the assumption that there
is at most one switch in the data series; i.e., that the first m (m un-
known) observations in a time series are generated by regime 1 and the
remaining n-m observations by regime 2. Problems of this type have
been analyzed in various ways by Brown and Durbin (1968), Farley
and Hinich (1970) and Quandt (1958, 1960).
This simple model, permitting only one switch, is clearly unrealistic
in some economic contexts. A more complex situation arises if it is as-
sumed that the system may switch back and forth between the two re-
gimes. Accordingly the first m 1 observations may come from regime 1,
the next m2 from regime 2, the next m3 from regime 1 again, etc., with
ml, m2, ... . m, (J& ml=n) being unknown. Under this assumption it is
theoretically possible for the system to switch between regimes every
time that a new observation is generated.
The basic purpose of this paper is to introduce a model that allows
for numerous switches. In sect. 2 we briefly describe two of our earlier
approaches to the many-switch case that will be important for what fol-
lows. These approaches have the basic characteristic that the probability
of a switch does not depend, at any time, on what regime is in effect. In
sect. 3 we describe a new statistical model that explicitly allows for such
a dependence. In sect. 4 we apply it to a concrete economic illustration.
In sect. 5 we make some suggestions for further extensions.

2. The Multiswitch problem

2.1. The D-method

The first of two recent approaches to this problem has been intro-
duced in Goldfeld and Quandt (1972). In this approach it is assumed
that ignorance about which regime generates an observation is only par-
tial; specifically it is assumed that there exist observations on some exo-
 S.M. Goldfeld, R.E. Quandt, Switching regressions 5

genous variables’ Zri, Z2i, . .. . Zpi (i=l, . .. . n), and that nature selects re-
gime 1 for generating the ith observation on the dependent variable if
an unknown function, possibly linear, of the z’s is less than or equal to
zero. Thus,

P
Yi=XJPl +&!li if C TjZjiG 0 (3)
i= 1

and

yi = Xi02 + U2i if A ITjZji > 0

j= 1

where the ni are unknown coefficients to be estimated. Introduce the

unit step function

P
d(z,) = 0 if C TjZji G 0
j= 1
(4)
P
d(Zi) = 1 if C ~iZii> 0
j= 1

and denote by D the diagonal matrix of order n which has d(Zi) in the
ith position of the main diagonal. Let Y be the n X 1 vector of observa-
tions on the dependent variable and X be the n X k matrix of observa-
tions on the independent variables. The problem of estimating the two
separate regimes is- then equivalent to estimating the 2k p’s, 20~‘s and n
d’s of the composite regression equation

Y = (I-D) xp1 + 0x/3, + +v 9

(5)

where W = (I-D) U, + DU2 is the vector of unobservable and hetero-

scedastic error terms. Denoting the covariance matrix of W by

A-2= (I-O)20~ + D2u; , (6)

* The z’s may, of course, include some or all the regressors.

6 S.M. Goldfeld, R.E. Quondt, Switching regressions

maximum likelihood estimates are obtained by maximizing

L = constant - + 1oglCII - 4{[ Y-(I-D)X& -OX& 1’

x 52--l[ Y-(I-@X/3, - m/3,]} . (7)

Estimating parameters by maximizing (7) in its given form is not prac-

tical because of the combinatorial aspects of the unit step function and
is not likely to yield consistent estimates.3 The problem becomes trac-
table from the practical point of view and the method yields consistent
estimates if the unit step function is replaced by a continuous approxi-
mation, say by

where u is a new parameter and must be estimated along with the ~j.
Maximum likelihood estimates are then obtained by maximizing (7),
subject to replacing d(zi) in (7) by the expression in (8), with respect to
the 2k p’s, p T’S and u.~

2.2. The X-method

An alternative method, introduced in Quandt (1972), assumes that

nature chooses between regimes 1 and 2 with probabilities X and 1 -X,
where X is unknown to the investigator. Then the conditional density of
yi is

htiiIXi> = Vlo/iIXi) + (l-~)f2cVilXi> = (9)

exp c_Yj-x:P2)2
l
-3
-3 3
=* u12 +g2exp i I

3 If the number of parameters to be estimated increases with the number of observations,

maximum likelihood estimates are not, in general, consistent. See Kendall and Stuart (1961),
p. 61.
4 For further discussion see Goldfeld and Quandt (1972), ch. 9. In addition, one may use the
estimated nj [or the estimated d(Zi)] to separate the sample and then apply standard estimating
techniques.
 S.M. Goldfeld, R.E. Quandt, Switching regressions

from which the loglikelihood function is

L = C 1Ogh~ilXi) (10)
i= 1

which may be maximized with respect to the o’s, u2’s and h.’ Both the
D-method and the h-method have been found to have acceptable sam-
pling properties. 6

3. A Markov model

The essence of the X-method as stated in the previous section is that

the probability that nature selects regime 1 or 2 at the ith trial is in-
dependent of what state the system was in on the previous trial. We
shall explicitly relax this assumption and introduce the matrix T of
transition probabilities, the (rs)th (r, s = 1, 2) element of which being the
probability that the system will make a transition from state r to state S,
i.e., that if in period i - 1 regime r was in effect then in period i regime
s will be in effect. This interpretation makes the regime switching pro-
cess a Markov chain. Denote the probability vector that the system is
initially in one or the other of the two states by XL = (h,, X2,) (where
of course X,, = 1 - X2,) and the corresponding probability vector at the
ith stage by Xi = (Xri hz). Then

and

X; = hb T'. (11)

In the conditional density function (9) for yi we now replace h by Xii:

h~ilXi> = Xlif~tjilxi) + (l-Xli)f2tiilxi) = AI-f;: (12)

‘An immediate extension of this method is obtained by allowing h to be a function of the

previously introduced exogenous variables z.
‘See Goldfeld and Quandt (1972) and Quandt (1972), as well as Goldfeld et al. (1971),
for a favorable contrast with a nonlinear least-squares procedure.
 8 SM. Goldfeld. R.E. Quandt, Switching regressions

where fi is the vector

1
f~CYilxi)
fi=
[ f2CYilxi)
*

Hence the loglikelihood function is in general

n

(13)

3.1. The basic model

We now let the matrix of transition probabilities be

T=

Defining tLs as the (rs)th element of Ti, the application of (11) then
yields the recursions

{r = rr&’ + (1-Q t&l

(14)
I!21 = (1 -r2) 6;’ + T2t;;l

with the initial conditions t: 1 = 71 and til = 1 - TV.The general solution

of the difference equation system ( 14) is then

Since, as before, Xi = (h1,,~11+h20~21, Xl,r’,,+X2,t’,,) substitution in

( 13) yields the requisite likelihood function as a function of the P’S, u2,
Xl,, 71, and 72. The method just described will be referred to as the T-
method.
3.2. An extension
The elements of the transition matrix may be made functions of an
extraneous variable z. Then we can write
 SM. Goldfeld, R. E. Quandt. Switching regressions

and also

If, for example, one assumed for theoretical reasons that large values of
z are associated with high probabilities of entering the first state, the T
functions might be defined by

q(q) =& j!ew 1-4(2,‘)

-00
d-E

and

r*(zi) = +fiu f exp [-j(q)*) dt.

=i

The likelihood function can then be derived and would have to be max-
imized with respect to the usual parameters as well as zcr, zo2, at, 022.
This last method will be referred to as the r(z) method.

4. An economic example

Recently Fair and Jaffee (1973) have proposed a model for a housing
market in disequilibrium in which the demand and supply functions are
specified as

yt = CYO+ CYlXlt+ “*X*t + “3X3t + u1t (16)

and

Yt = & + alXlt + P4X4t + PgX5t + f16x6t + ‘21 ’ (17)

where yr is the observed number of housing starts in month t: x1 t is a

time trend, x2t a measure of the stock of houses, x3t the mortgage rate
lagged two periods, xqt a moving average of private deposit flows in
10 S.M. Gbldfeld, R. E. Quandt, Switching regressions

savings and loan associations and mutual savings banks lagged one peri-
od, xsr a moving average of borrowings by savings and loan associations
from the Federal Home Loan Bank lagged two periods and x6t = x3[+r.
If there is an excess demand, the observed point lies on the supply func-
tion and if there is an excess supply, it lies on the demand function: at
least formally, therefore this is a two-regime problem. Among other
methods, Fair and Jaffee estimated the model by segregating data points
into two subgroups according to whether a point belonged to a period
of.rising or falling price (mortgage rate): if price was rising there must
have been an excess demand and the corresponding points may be used
to estimate the supply function and conversely for points belonging to
periods of falling price .7 111effect they thus posited the existence of a
z-variable with an implied approximation of the form of (8) given by

d(zi) = & i: exp i-4 (2)‘) dE (18)

where z. was explicitly assumed to be zero. Their model was reesti-

mated in Goldfeld and Quandt (1972), employing the D-method where
z. was taken to be a parameter to be estimated.8
It was pointed out by Fair and Kelejian (1972) that neither the pro-
cedures in Fair and Jaffee (1973), nor Goldfeld and Quandt (1972) are
legitimate since they imply data segregation determined by price change
which is itself endogenous. The resulting estimates are hence biased. An
obvious alternative, therefore, is to neglect the extraneous information
about the z’s and make use of the X-method and this was accomplished
in Quandt (1972). As previously indicated, according to this the probab-
ility of observing a period of excess demand does not depend on wheth-
er the previous period was one of excess demand or not. It thus seems
natural to reestimate the model using the r-method of sect. 3 but be-
fore doing so we need one further elaboration.
It had been previously observed that the error terms in the two re-
gimes ‘are autocorrelated. It was therefore necessary to derive a likeli-
hood function that would permit the estimation of autocorrelation
coefficients p1 and p2. Unfortunately there are numerous ways of speci-

7 Many observations were associated with zero price change. These are then presumably
equi$brium observations and were treated in various ways by Fair and Jaffee.
This is clearly equivalent, in the terms of (4) to having two z’s with zti having values of
unity, Zzi being the price changes, nt = -20. and “2 = 1.
 S.M. Goldfeld, R.E. Quandt, Switching regressions 11

fying the error generating mechanism in the presence of autocorrelation

and switching regimes. The method adopted here was the simplest, al-
though not the most reasonable one, according to which the equations
are written

and

yi-pfli_1 -(x~-P2xI-1)132= ‘2i 9 (19)

and where Eli and ~2i are posited to be independent; the r-method is
then applied to the conditional densities of yi-_Plyi_ 1 and yi-p2yi_ 1.
The resulting likelihood function was maximized with respect to 16
parameters (9 (Y’Sand p’s, 2 u2’s, 2 p’s, A,,, 71 and r2). The estimates
and their ratios to the square roots of their asymptotic variances to-
gether with the corresponding figures for the X-method are displayed in
table 1.
From r1 and 72 and (15) the limit probability of state 1 is 0.192.
This is remarkably close to the previous estimate of the fraction of
observations associated with Regime 1 which was given by h = 0.181.
The reasonableness of the estimates for r1 and r2 can be checked in
another way as well. Let T be the transition matrix, let A be the matrix
which has the ith limit probability repeated as its ith column. Define:

2 = (I-(T-A))-’ ,

and let Zdg be the matrix 2 with its off-diagonal elements replaced by 0;
let E be a matrix of all l’s and D a diagonal matrix with ith diagonal
element equal to the reciprocal of the ith limit probability. Then the
mean first passage matrix M is given by9

A4 = (I-Z+EZdg) D

and the variance of the first passages by

V = M(2ZdgD-I) + 2(ZM-E(ZM),,) .

Let S be the matrix containing the square roots of the elements of V.

9 See Kemeny and Snell(1960), pp. 79-83.

 12 S.M. Goldfeld, R. E. Quandt, Switching regressions

Table 1

h-method s-method

Estimate/approx. Estimate/approx.
Estimate std. dev. Estimate std. dev.

190.09 4.23 193.533 3.15

2.25 3.26 2.116 0.93

-0.016 -2.13 - 0.020 -0.80

-0.195 -2.50 - 0.193 1.78

-4.58 -0.14 -37.900 -0.84

0.247 -2.66 - 0.330 -2.58

0.057 6.39 0.059 4.93

0.033 3.79 0.035 3.50

0.143 2.72 0.199 2.66

27.53 2.04 72.890 0.66

34.45 4.85 42.591 2.68

0.538 5.16 0.513 2.54

0.698 9.71 0.717 7.62

- - 0.916 5.38

- - 0.980 28.82
0.181 2.13 - -

_ _ _*
Al0 0.120

* No standard deviation is reported since the optimum was achieved by scanning over alterna-
tive values of Ale and maximizing jointly with respect to the remaining parameters.

Computing these quantities in the present case yields

Thus, if we are on the demand function, it takes an average of 5.19

steps to be on the demand function again; if we are on the supply func-
tion it takes only 1.24 steps.
 S.M. Goldfeld, R. E. Quandt, Switching regressions 13

A totally different estimate of M can be obtained by utilizing the ex-

traneous variable ‘price change’, as suggested by Fair and Jaffee. The
application of the D-method results in an estimate of z. and u2 which
leads to d(zi)-values that allocate observations with zero price change
essentially to the supply function. Thus one can count directly from
the time series the average number of periods that it takes to enter any
regime from any regime. This yields a new estimate M* for the mean
first passage matrix which is based on considerations quite independent
of the r-method. M* is

The diagonal elements show remarkable agreement. The off-diagonal

elements clearly agree less well. However, the difference between them
is still well within a one-u range as is shown by the elements of S.
On the whole, the r-method is both computationally feasible and
yields reasonable results. In the present example the results are quite
similar to the ordinary X-method (this is not surprising in view of the
closeness of the estimated r’s to unity) but in other applications this
hardly need be the case.

5. Some possible extensions

Sects. 2 and 3 contain a variety of methods for estimating switching

regressions that allow for multiple switches in regimes. These methods
allow basically two kinds of patterns in the switching mechanism. The
essence of the first pattern is that the probability of choosing a regime
is either a constant’or depends only on the immediately previous state
of the system (X and r methods). The second pattern permits a deter-
ministic choice of regimes depending upon an extraneous variable (D-
method). These two patterns may be combined yielding a probabilistic
choice between regimes which depends on an extraneous variable (as in
h(z) and r(z) methods).
None of these methods allows the choice of a regime to depend on
the historical record of regimes in the sense that the current selection of
regimes is influenced neither by the number of times a given regime has
prevailed nor by the temporal pattern of regime choices. There are
many economic applications where such inertial dependence might be
14 S.M. Goldfeld, R.E. Quandt, Switching regressions

desirable. For example, in the application discussed in sect. 4, periods

of excess demand (or supply) may have a tendency to persist. One
might thus like a model which allowed the probability of entering a
period of excess demand to tend to rise if excess demand has prevailed
in the past.‘O
One of several possible ways of accomplishing this is to specify Xi
(the probability of choosing the first regime) as

Xi=p(l-6i_l)+(1-P)xi-1 ) (20)

where 0 < p < 1 and where 6i_ r = 0 if in the previous period the first
regime prevailed and 6i_ 1 = 1 otherwise. For p = 0, the procedure im-
plied by (20) is simply the h-method. For p = 1, the system perpetually
remains in the regime in which it was in the initial period. For inter-
mediate values, the higher the value of p the more Xi tends to reflect
predominantly the state of the system in the previous period. As a mat-
ter of practical implementation, it is clear from (20) that the Xi can
take on 2’- 1 different values, each expressible in terms of X0, 6, and p.
The probabilities corresponding to these values can be computed as
functions of these same parameters. The values of the Xi and their prob-
abilities can then be combined in the usual manner to form the likeli-
hood function which is then expressed entirely in terms of the p’s, u’s
and X0, 6, and p.
Another extension which allows switching between states that in-
volves temporal persistence may be specified. This extension has the
feature that in some periods the system obeys regime 1, in some others
regime 2, and in still some others it obeys a transitional hybrid between
the two regimes.
Let D be a diagonal matrix as in (5) but do not require its elements
di to be 0 or 1. Of course if di is 0 or 1 we are entirely in one or the
other regime; otherwise nature is assumed to generate yi from a hybrid
regime. Let r(Zi) be defined by

exp (-4 (%)*I dt .

lo This could, of course, come about for T(Z), A(Z) or D-methods if the z-variable behaved
appropriately but it is obviously desirable to allow for this possibility more generally.
 S.M. Coldfeld, R. E. Quandt, Switching regressions 15

We now let

di = Pdi_1 + ( 1-p) y(zi) (21)

where 0 i p < 1 and with the initial condition d, = I. It follows

from (21) and the initial condition that

Replacing the elements of D in (5) by (22) the likelihood function is

expressed as a function of the unknown p and of the unknown za and
u. In the extreme case when p = 0 there is no temporal persistence in
the switching process and the degree of hybridization depends only on
z. Otherwise, the degree of hybridization depends on the value of p.

References

Brown, R.L. and J. Durbin, 1968, Methods of investigating whether a regression relationship is
constant over time, Paper presented at the European Statistical Meeting, Amsterdam.
Chow, G., 1960, Tests of the equality between two sets of coefficients in two linear regressions,
Econometrica 28, 561-605.
Fair, R.C. and D.M. Jaffee, 1973, Methods of estimation for markets in disequilibrium, Eco-
nometrica, forthcoming.
Fair, R.C. and H.H. Kelejian, 1972, Methods of estimation for markets in disequilibrium: A
further study, Econometric Research Program, Research Memo. No. 135, Princeton Uni-
versity, Jan. 1972.
Farley, J.U. and M.J. Hinich, 1970, A test for a shifting slope coefficient in a linear model,
Journal of the American Statistical Association 65, 1320-1329.
Goldfeld, SM., H.H. Kelejian and R.E. Quandt, 1971, Least squares and maximum likelihood
estimation of switching regressions, Econometric Research Program, Research Memo. No.
130, Princeton University, November 1971.
Goldfeld, SM. and R.E. Quandt, 1972, Nonlinear Methods in Econometrics (North-Holland
Publishing Co., Amsterdam).
Kemeny, J.G. and J.L. Snell, 1960, Finite Markov Chains (D. Van Nostrand, Inc.).
Kendall, M.G. and A. Stuart, 1961, The Advanced Theory of Statistics, Vol. II (Hafner, New
York).
Quandt, R.E., 1958, The estimation of the parameters of a linear regression system obeying two
separate regimes, Journal of the American Statistical Association, 53, 873-SRO.
Quandt, R.E., 1960, Tests of the hypothesis that a linear regression system obeys two separate
regimes, Journal of the American Statistical Association 55, 324-330.
Quandt, R.E., 1972, A new approach to estimating switching regressions, Journal of the Ameri-
can Statistical Association 67, 306-310.