Okun's law
Encyclopedia
In economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, Okun's law is an empirically
Empirical research
Empirical research is a way of gaining knowledge by means of direct and indirect observation or experience. Empirical evidence can be analyzed quantitatively or qualitatively...

 observed relationship relating unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

 to losses in a country's production first quantified by Arthur M. Okun. The "gap version" states that for every 1% increase in the unemployment rate, a country's GDP
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....

 will be at an additional roughly 2% lower than its potential GDP. The "difference version" describes the relationship between quarterly changes in unemployment and quarterly changes in real GDP
Real GDP
Real Gross Domestic Product is a macroeconomic measure of the value of output economy adjusted for price changes . The adjustment transforms the money-value measure, called nominal GDP, into an index for quantity of total output...

. The accuracy of the law has been disputed. The name refers to economist
Economist
An economist is a professional in the social science discipline of economics. The individual may also study, develop, and apply theories and concepts from economics and write about economic policy...

 Arthur Okun who proposed the relationship in 1962.

Imperfect relationship

Okun's law is more accurately called "Okun's rule of thumb" because it is primarily an empirical observation rather than a result derived from theory. Okun's law is approximate because factors other than employment (such as productivity) affect output. In Okun's original statement of his law, a 3% increase in output corresponds to a 1% decline in the rate of unemployment; a .5% increase in labor force participation; a .5% increase in hours worked per employee; and a 1 % increase in output per hours worked (labor productivity
Labor productivity
Workforce productivity is the amount of goods and services that a worker produces in a given amount of time. It is one of several types of productivity that economists measure. Workforce productivity can be measured for a firm, a process, an industry, or a country...

).

Okun's law states that a one point increase in the unemployment rate is associated with two percentage points of negative growth in real GDP. The relationship varies depending on the country and time period under consideration.

The relationship has been tested by regressing GDP or GNP growth on change in the unemployment rate. Martin Prachowny estimated about a 3% decrease in output for every 1% increase in the unemployment rate (Prachowny 1993). The magnitude of the decrease seems to be declining over time in the United States. According to Andrew Abel and Ben Bernanke
Ben Bernanke
Ben Shalom Bernanke is an American economist, and the current Chairman of the Federal Reserve, the central bank of the United States. During his tenure as Chairman, Bernanke has overseen the response of the Federal Reserve to late-2000s financial crisis....

, estimates based on data from more recent years give about a 2% decrease in output for every 1% increase in unemployment (Abel and Bernanke, 2005).

There are several reasons why GDP may increase or decrease more rapidly than unemployment decreases or increases.
As unemployment increases,
  • a reduction in the multiplier effect created by the circulation of money from employees
  • unemployed persons may drop out of the labor force
    Labor force
    In economics, a labor force or labour force is a region's combined civilian workforce, including both the employed and unemployed.Normally, the labor force of a country consists of everyone of working age In economics, a labor force or labour force is a region's combined civilian workforce,...

     (stop seeking work), after which they are no longer counted in unemployment statistics
  • employed workers may work shorter hours
  • labor productivity may decrease, perhaps because employers retain more workers than they need


One implication of Okun's law is that an increase in labor productivity
Productivity
Productivity is a measure of the efficiency of production. Productivity is a ratio of what is produced to what is required to produce it. Usually this ratio is in the form of an average, expressing the total output divided by the total input...

 or an increase in the size of the labor force
Labor force
In economics, a labor force or labour force is a region's combined civilian workforce, including both the employed and unemployed.Normally, the labor force of a country consists of everyone of working age In economics, a labor force or labour force is a region's combined civilian workforce,...

 can mean that real net output
Net output
Net output is an accounting concept used in national accounts such as the United Nations System of National Accounts and the NIPAs, and sometimes in corporate or government accounts. The concept was originally invented to measure the total net addition to a country's stock of wealth created by...

 grows without net unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

 rates falling (the phenomenon of "jobless growth").

Mathematical statements

The gap version of Okun's law may be written (Abel & Bernanke 2005) as:
, where:
  • is potential output or GDP at full-employment
  • is actual output
  • is the natural rate of unemployment
  • is actual unemployment rate
  • is the factor relating changes in unemployment to changes in output


In the United States since 1955 or so, the value of c has typically been around 2 or 3, as explained above.

The gap version of Okun's law, as shown above, is difficult to use in practice because and
can only be estimated, not measured. A more commonly used form of Okun's law, known as the difference or growth rate form of
Okun's law, relates changes in output to changes in unemployment:
, where:
  • and are as defined above
  • is the change in actual output from one year to the next
  • is the change in actual unemployment from one year to the next
  • is the average annual growth rate of full-employment output


At the present time in the United States, k is about 3% and c is about 2, so the equation may be written

The graph at the top of this article illustrates the growth rate form of Okun's law, measured quarterly rather than annually.

Derivation of the growth rate form of Okun's law

We start with the first form of Okun's law:
Taking annual differences on both sides, we obtain
Putting both numerators over a common denominator, we obtain
Multiplying the left hand side by , which is approximately equal to 1, we obtain
We assume that , the change in the natural rate of unemployment, is approximately equal to 0. We also assume that , the growth rate of full-employment output, is approximately equal to its average value, . So we finally obtain
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