Okun’s Law - Relationship Between Unemployment And Economic Growth

Okun's law is an observed relationship between a country's GDP (or GNP) and employment levels.

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Definition

Macroeconomic relationship between unemployment and economic growth. According to this law, for every 2% decrease in real GDP relative to potential GDP, the unemployment rate increases by 1 percentage point. This means that unemployment, exceeding a certain threshold, has a negative impact on GDP, reducing the possibilities of potential production.

Genesis

The most severe consequence of any recession is an increase in the unemployment rate. When production falls, enterprises need less labor, so they stop recruiting new employees and reduce existing employment. It turns out that unemployment during the business cycle follows production. This significant interdependence of production and unemployment discovered by Arthur Okun is called Okun's law.

The basic conclusions and premises in macroeconomic policy from Okun's law is the observation of GDP:

• real GDP must grow at the same rate as potential GDP to prevent unemployment from rising,
• in a sense, GDP must maintain its momentum for unemployment to remain constant,
• In order to reduce the unemployment rate, real GDP must grow faster than potential GDP.

Okun's Law thus provides the key to understanding the relationship between the product market and the labor market. It describes the relationship between short-term changes in real GDP and changes in unemployment.

Variability of Okun's law

Okun's law is not a result obtained from theory. This law is based on observations and empirical results. The obtained results are only an approximation, because in addition to unemployment, other factors are also taken into account, i.e. technology or productivity. Despite the relationship between economic growth and unemployment shown by A. Okun, this relationship may be different for each country depending on the time of the study (A. Salomon, p. 16). Therefore, Okun's rule can be presented in various formulas:

• difference version,
• gap version,
• dynamic version,
• production-function version

In 1993, Martin Prachowny estimated that for every 1% increase in unemployment, there is about a 3% decrease in output. He believed, however, that most of the change in production that occurs is due to changes in factors other than unemployment.

Is Okun's law true?

While Okun's law has proven true at certain times in history, there have also been conditions where it has not been true. The Federal Reserve Bank of Kansas City conducted a 2007 review of Okun's law by looking at quarterly changes in unemployment and comparing this data to quarterly growth in real product.

According to their findings, Okun's law was largely accurate, although there were many periods of instability where unemployment did not change as predicted by the formula. The study found that "Okun's law is not an exact relationship" but "predicts that slowing growth tends to coincide with rising unemployment."

The review found a negative correlation between quarterly changes in employment and productivity, although the ratio of this relationship tended to fluctuate.

In other studies, Okun's law worked out better than the researchers expected. Although early GDP data suggested that the Great Recession was a departure from Okun's law, later revisions of this data largely confirmed the law's predictions.

Example

The years 1979-1982 were a period of economic stagnation. During this period, there was no real GDP growth as opposed to potential GDP, which had a growth rate of over 3% per year. How has this affected the unemployment rate? Recall that for every 2% of GDP shortfall in relation to the potential level, 1 percentage point is added to the unemployment rate; a 9% shortfall in GDP should lead to an increase in the unemployment rate by 4.5 percentage points. Starting with an unemployment rate of 5.8% in 1979, according to Okun's law, the projected unemployment rate in 1982 should be 10.3%. Official statistics recorded a slightly lower unemployment rate of 9.7% for 1982. This example shows how Okun's law can be applied to predict unemployment over the course of a business cycle.

Source: Smith P., Beeg D., Ekonomia, Salomon A., Zatrudnienie i bezrobocie