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Contagious Switching

We analyze the propagation of recessions across countries. We construct a model that allows for multiple qualitative state variables in a vector autoregression (VAR) setting. The VAR structure allows us to include country-level variables to determine whether policy also propagates across countries. We consider two different versions of the model. One version assumes the discrete state of the economy (expansion or recession) is observed. The other assumes that the state of the economy is unobserved and must be inferred from movements in economic growth. We apply the model to Canada, Mexico, and the United States to test if spillover effects were similar before and after the North American Free Trade Agreement (NAFTA). We find that trade liberalization has increased the degree of business cycle propagation across the three countries.

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