Okun's Law

In economics, Okun's Law provides a simple yet powerful tool for understanding the relationship between economic growth and unemployment. Offering a clear explanation, a concise formula, and an illustrative diagram, this article will uncover the mechanics of Okun's Law and its implications for policymakers. We'll also work on an example of the calculation of Okun's coefficient. However, as with any economic model, it is essential to acknowledge its limitations and explore alternative explanations to grasp the whole picture.

Okun's Law Explanation

Okun's law is an analysis of the link between unemployment and rates of economic growth. It is designed to inform the people how much of a nation's gross domestic product (GDP) might well be compromised when the unemployment rate is over its natural rate. More precisely, the law specifies that the GDP of a nation must increase by 1% above potential GDP in order to obtain a 1/2% drop in the rate of unemployment.

Okun's Law has a straightforward rationale. Because the output is determined by the quantity of labor utilized in the manufacturing process, a negative link exists between unemployment and production. Total employment is equal to the labor force minus the number of unemployed, implying an inverse connection between production and joblessness. As a result, Okun's Law may be quantified as a negative link between changes in productivity and changes in unemployment.

Okun's Law: The Difference Version

Okun's initial connection recorded how quarterly fluctuations in the rate of unemployment shifted with quarterly development in real production. It turned into:

\({Change\ in\ Unemployment\ Rate} = b \times {Real\ Output\ Growth}\)

This is known as the difference version of Okun's law. It captures the connection between production growth and variations in unemployment—that is, how output growth fluctuates concurrently with variations in the rate of unemployment. The parameter b is also known as Okun's coefficient. It would be expected to be negative, implying that output growth is related to a dropping rate of unemployment while sluggish or negative production is linked to a rising rate of unemployment.

Okun's Law: The Gap Version

Although Okun's initial connection was based on easily attainable macroeconomic data, his second connection linked the degree of unemployment to the difference between possible and real output. Okun aimed to determine how much the economy would produce under full employment in terms of potential production. He viewed full employment as a level of unemployment low enough for the economy to produce as much as possible without causing excessive inflationary pressure.

He argued that a significant rate of unemployment would often be linked to inactive resources. If that were the truth, one might anticipate that the real rate of output would be lower than its potential. The opposite scenario would be linked with an extremely low unemployment rate. As a result, Okun's gap version adopted the following form:

\({Unemployment\ Rate} = c + d \times {Output\ Gap\ Percentage}\)

The variable c represents the rate of unemployment linked to full employment (the natural rate of unemployment). To comply with the aforementioned notion, the coefficient d must be negative. Both potential production and full employment have the disadvantage of not being readily observable statistics. This results in a great deal of interpretation.

For example, at the point in time that Okun was publishing, he believed that full employment happened when joblessness was at 4%. He was able to develop a trend for potential output based on this supposition. However, modifying the supposition of what rate of unemployment constitutes full employment results in a different estimate of potential production.

Okun's Law Formula

The following formula shows Okun's Law:

\(u = c + d \times \frac{(y - y^p)} {y^p}\)

\(\hbox{Where:}\)\(y = \hbox{GDP}\)\(y^p = \hbox{Potential GDP}\)\(c = \hbox{Natural Rate of Unemployment}\)

\(d = \hbox{Okun's Coefficient}\)\(u = \hbox{Unemployment Rate}\)\(y - y^p = \hbox{Output Gap}\)\(\frac{(y - y^p)} {y^p} = \hbox{Output Gap Percentage}\)

Essentially, Okun's Law predicts the unemployment rate to be the natural rate of unemployment plus Okun's coefficient (which is negative) multiplied by the output gap. This shows the negative relationship between the unemployment rate and the output gap.

Okun's Law Example: Calculation of Okun's Coefficient

To gain a better understanding of how this works, let's go through an example of Okun's Law.

The diagram below (Figure 1) shows the general illustration of Okun's law using fictitious data. How so? Well because it demonstrates that changes in unemployment are accurately followed and predicted by the rate of GDP growth!

Figure 1. Okun's Law, StudySmarter

As shown in Figure 1, as the rate of unemployment increases, the rate of real GDP growth slows down. As the main parts of the graph follow a steady drop instead of a sharp decline, the general consensus would be that the Okun's Law parameter would be fairly stable.

Limitations of Okun's Law

Although economists support Okun's Law, it has its limitations and it isn't universally accepted as being completely accurate. Aside from unemployment, several other variables influence a country's GDP. Economists believe there's an inverse link between unemployment rates and GDP, although the amount to which they are influenced differs. Much research on the link between unemployment and output takes into account a broader range of factors like the size of the labor market, the number of hours worked by employed people, employee productivity statistics, and so on. Since there are many factors that can contribute to changes in the rate of employment, productivity, and output, this makes precise projections solely based on Okun's law challenging.