Okun’s Law: Economic Growth and Unemployment

When studying the economy, growth and employment are the two main factors that economists must consider. There is an obvious relationship between the two, and many economists try to construct a discussion by studying the relationship between economic growth and unemployment. The economist Arthur Okun first started discussing this issue in the 1960s, and his research on the subject has since been called Okun’s law. Below is a more detailed overview of Okun’s Law, its importance, and how it has withstood the test of time since it was first published.

Key points

  • Okun’s Law was proposed by Yale University professor and economist Arthur Aokun in the early 1960s.
  • Okun’s Law focuses on the statistical relationship between a country’s unemployment rate and economic growth rate.
  • Okun’s Law stipulates that a country’s gross domestic product (GDP) must grow at a rate of about 4% within a year in order to reduce the unemployment rate by 1%.

Okun’s Law: The Basics

The most basic form of Okun’s Law is to investigate the statistical relationship between a country’s unemployment rate and its economic growth rate. The Economics Research Department of the St. Louis Federal Reserve Bank explained that Okun’s Law “is designed to tell us how much a country’s gross domestic product (GDP) may be lost when the unemployment rate is higher than the natural rate.” It went on to explain. : “The logic behind Okun’s Law is simple. Output depends on the amount of labor used in the production process, so there is a positive correlation between output and employment. Total employment is equal to labor minus the number of unemployed, so output and unemployment are There is a negative correlation between them (conditions on labor).”

Yale University professor and economist Arthur Okun was born in November 1928 and died in March 1980 at the age of 51. He first published his findings on this subject in the early 1960s, and these findings have since been called his “laws.” Okun’s Law is essentially an empirical rule for explaining and analyzing the relationship between employment and growth. The speech of former Federal Reserve Chairman Ben Bernanke may be the most concise summary of the basic concepts of Okun’s Law.

“This rule of thumb describes the observed relationship between changes in the unemployment rate and the growth rate of real gross domestic product (GDP). Okun pointed out that due to the continuous growth of labor force size and productivity levels, it is usually necessary for real GDP growth to be close to its potential growth rate. In order to keep the unemployment rate stable. Therefore, in order to reduce the unemployment rate, the economic growth rate must exceed its potential. More specifically, according to the currently accepted version of Okun’s Law, the unemployment rate must be reduced by one percentage point in a year. Real GDP The growth rate must be approximately two percentage points faster than the potential GDP growth rate during the period. So, for example, if the potential GDP growth rate is 2%, Okun’s Law stipulates that GDP must grow at a rate of about 4% within a year In order to reduce the unemployment rate by 1 percentage point.”

How does Okun’s Law describe unemployment?

Learn more about Okun’s law

The most important thing is to note that Okun’s law is a statistical relationship that relies on the regression of unemployment and economic growth. Therefore, depending on the economic growth pattern, running regression may result in different coefficients used to solve for changes in unemployment. It all depends on the time period and input used, that is, historical GDP and employment data. Here is an example of Okun’s law regression:

The law does evolve over time to adapt to the current economic environment and employment trends. A version of Okun’s Law states very simply that when the unemployment rate drops by 1%, the gross national product (GNP) rises by 3%. Another version of Okun’s Law focuses on the relationship between unemployment and GDP, that is, an increase in the unemployment rate will cause a 2% drop in GDP.

A Bloomberg article integrated data from the highly volatile Great Recession period stated, “The rule of thumb is that every single percentage point of year-on-year growth exceeds the trend rate—the Fed’s policymakers set it at 2.3% to 2.6%— The unemployment rate fell by half a percentage point.”Please pay attention to the different uses of economic growth, such as GNP and GDP, and what are potential economic growth indicators.

Okun’s Law was established at different times, but it was not proven to be correct during the 2008 financial crisis.

Over time, does it hold true?

As with any law in economics, science, or any discipline, it is important to determine whether it holds under different conditions and over time. Regarding Okun’s Law, it seems that there are some conditions that it is very applicable, while others are not. For example, the Federal Reserve Bank of Kansas City’s review of Okun’s Law detailed that Okun’s first relationship looked at quarterly changes in the unemployment rate compared to the quarterly growth in actual output, and it seemed to hold up.

There are also different ways to track unemployment. Of course, the main testing ground for Okun’s Law has always been the United States. Austrian also analyzed the gap between potential economic output and the actual output rate in the economy. The Kansas City study detailed the different versions of Okun’s Law. Starting from his initial quarterly relationship, a “gap version” that looks at the difference between actual and potential output, including whether the law is in full employment or even high unemployment. Conditions are established. It chose a more dynamic version, with the option of leaving or adding variables based on the current and historical economic growth levels.

How useful is Okun’s law?

Despite the fact that there are many variables in the relationship between unemployment and economic growth, there seems to be empirical support for the law. The Kansas City Fed’s research concluded that “Okun’s Law is not a close relationship,” but it “predicts that slower growth usually coincides with rising unemployment.”Regarding the fact that it was not so useful during the financial crisis, Bernanke speculated that “the apparent failure of Okun’s Law may partly reflect statistical noise.”

Other studies support Okun’s law. The St. Louis Federal Reserve Bank concluded that “Okun’s Law can be a useful guide for monetary policy, but only if the natural rate of unemployment is properly measured.”

Bottom line

Generally speaking, Okun’s Law is one of the most direct and convenient methods to study the relationship between economic growth and employment. There is hardly any dispute about this. One of the main benefits of Okun’s Law is its simple statement that when the economy grows 2% faster than expected, the unemployment rate will drop by 1%. However, in view of economic growth trends, relying on it to make specific predictions of unemployment does not work well. For example, since studying it, people have known that it will change over time and will be affected by more unusual economic climates, including unemployment recovery and the 2008 financial crisis.

The analysis can become very complicated due to the complexity of the input, the different time periods that can be used, and the basic uncertainty of running an economic regression. Okun’s Law may not be entirely predictive, but it can help to structure discussions about economic growth, how employment affects economic growth, and vice versa.

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