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There Are Two Okun's Law Relationships between Output and Unemployment

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There Are Two Okun's Law RelationshiPt Between Ouþut and
Unemplolmtent

Humberto Bameto and Frank Howland*


Wabash College

Abstract
This paper corrects a fundamental error in the literature examining the
Okun's Law relationship between the unemployment rate and the rate of
growth of output. Since Okun's original work, biased estimates of the Okun
Coeffrcient on Unemployment, output gâps, and potential GNP have been
reported by authors who mistakenly assume that unbiased coeffrcient
estimates of the reverse regression are reciprocals of their direct regression
analogues. Thus, for example, there is no need to explore a wide variety of
alternative answers to the "puzzle" of an extremely high Okun coefficient in
Japan -- the extremely large value is merely a statistical artifact.
'

(JEL Classification Numbers: C1, 83, E6)

Submitted to the European Economíc Reaiew


74 April1994

Address correspondence to
Humberto Barreto, Wabash College Crawfordsville, IN 47933 USA
FAX: (317) 3il4295
E-mail: barretoh@wabash.edu
1.0 INTRODUCTION
This paper emphasizes that the research question determines the direction of
regression. This insight allows us to correct a fundamental error in the Okun's Law
literature concerning the magnitude and interpretation of coefficients from the
direct and reverse regressions of unemployment on output.
In L962, Arthur Okun found a clever solution to the difficult problem of
estimating an economy's potential output. Instead of simply measuring the trend of
GNP over time and calculating the GNP gap as the deviation of actual GNP from
trend, Okun exploited the dependable relationship between the rate of growth of
ouþut and the unemployment rate (now commonly known as Okun's Law) in
order to estimate potential output given actual unemployment.
Unfortunately, Okury and many others following in his footsteps, mistakenly
assumed that it is valid to use the reciprocal of the slope of the regression of
unemployment on output when making a prediction of output given
unemployment. In fact, the best linear predictor of output given unemployment is
found by regressing output on unemployment.l Running the regression in the
correct direction results in substantially lower estimates of Okun's coefficient, the
GNP gap, and potential GNP. The issue is confused, however, because there are
situations (e.g., predicting the change in unemployment given changes in output)
when regressing unemployment on output is appropriate. For Okun's Law, the key
points are that (1) predicting full-employment GNP requires estimation of the
conditional expectation function of GNP given unemployment (rendering moot the
question of theoretical justification for a particular causal relationship) and, (2) once
the direction of the regression is determined, it is the coefficient on the regressor,
not its reciprocal, which is of interest.
Today, much more sophisticated approaches are followed in the estimation of
potential output, calculation of the GNP gap, and forecasting unemployment.
Flowever, Okun's Law remains a staple of modern macroeconomics and to the

2
extent that it is still used as a rough rule of thumb, it must be done correctly. When
done so, Okun's Law continues to provide a pretty good approúmation.
The next section examines the relationship between the direct and reverse
regressions and defends our view that the question at hand determines which
regression is appropriate. Section 3 replicates and corrects Okun's original research.
Running the correct regression and using the correct Okun Coefficient on
Unemployment2 reveals that, for the 1947-1960 period, percentage point decreases in
the trnemployment rate are associated with approximately 2o/o increases in GNP, not
3o/o or 3.2"/" as Okun reported. The last section reviews recent research on Okun's
Law in light of the fact that the direction of the regression must be correctly chosen.
We find that the puzzle of the extremely high, reported Okun Coefficient on
Unemployment in ]apan is due in large part to the systematic error inherent in
running the wrong regression for the question asked and using the reciprocal of the
coefficient estimate as a measure of the change in output given changes in
unemployment.

2.0 COMPARING THE DIRECT AND REIrERSE REGRESSIONS


In describing the linear relationship between any two variables X and Y, one
must make a choice between two regressions: Y on X and X on Y. We sbess that
whether regression is appropriate and, if so, the choice of which regression to use
depends upon (1) the assumptions one makes about the process that generated the
data and (2) the question one is asking. Okun and almost all of the later literature
have not dealt explicitly with these issues and much confusion has resulted.3 In
this section we extend the logic of Okun's arguments to cover these issues.

2.1 Determining When Regression is Appropriate


Okun's idea was to use deviations in unemployment from full employment
to predict deviations in actual GNP from potential GNP based on the past

3
relationship between unemployment and GNP. This idea will work only if there is
a consistent relationship between the two variables. There is no necessary reason
that there should be a stable relationship between unemployment and GNP. A
modern, sophisticated econometric model of the macroeconomy would make both
variables endogenous. If any of the sbuctural parameters of the model were to
change, the relationship between GNP and unemployment would change.
Thus, Okun's procedure makes sense only if the underlying structure in the
model is assumed to be stable, i.e., if the parameters of the model do not change
between the sample period and the date on which the GNP gap is to be predicted. If
any of the structural parameters have changed in the intervening time, then the
sample relationship will produce biased estimates of the GNP gap. Therefore, to
correctly apply Okun's logic, the observed values of GNP and unemployment in the
period for which potential output is to be predicted should be modeled as draws
from the same process that produced the sample data. Okun's procedure is not to be
interpreted as estimating parameters of a well specified economic model that
captures an unchang^g, single linear relationship between unemployment and
GNP.

2.2 Determining whích Regression is Correct


Okun's analysis, therefore, implicitly assumes that the underlying sbucture of
the macroeconomy does not change between the sample period and the date on
which the GNP gap is to be computed. We shall make this assumption in our
discussion of Okun's Law. The question remains: Which regression is relevant to
describe the relationship between GNP and unemployment, GNP regressed on
unemployment or unemployment regressed on GNP? The answer varies according
to what type of prediction one wishes to make. If one wishes to predict
unemployment given a certain level of GNP, one should use the regression of
unemployment on GNP; if one wishes to predict GNP given a specific level of
unemployment, one should use the regression of GNP on unemployment.

4
Most economists writing in the Okun's Law literature have disagreed. They
have treated the regressíon of unemployment on GNP as if they were estimating an
unchanging parameter of a causal model and have then used the reciprocal of the
estimated parameter to predict GNP given unemployment. This interpretation of
the Okun's Law relationship assumes that (1) there is a stable relationship between
GNP and unemploymenÇ and (2) the observed value of the change in
unemployment can be treated as if it were generated by fixing the change in GNP,
applying a linear transformation, and adding a disturbance term which is
uncorrelated with the change in GNP. In this case, the only way to make sense of
the data and the only parameter of interest is the one multiplying GNP in the
equation with unemployment as the dependent variable. Thus, only the regression
of unemployment on GNP should be estimated.
We argue that this model of the data generation process makes little sense.
The assumption of a stable relationship between output and unemployment
remains indispensable, but we replace the second assumption with the following
description of the data generation process: observed changes in unemployment and
changes in GNP are draws from a joint distribution of random variables. The
current data can be treated as a draw from the same bivariate population that
generated past data points. The task of the researcher is to predict either (1)
unemployment given GNP or (2) GNP given unemployment. The task will
determine the direction of regression.4
Thus, for the purposes to which Okun wishes to put them, regressions
involving unemployment and GNP make sense only as best linear predictors of
either unemployment given GNP or GNP given unemployment. A simple model
relating two variables Y and X should provide more intuition regarding the
differences between estimating a model parameter and prediction and between the
results of the direct and reverse regressions.

5
Suppose this model describes the relationship between Y and X:

(2.2.1) Y=u.+pX+e,

where E[e lX] = 0 for all values of X. Then

(2,2.2) ElYlXl=a+ÞX

is the conditional expectation function of Y given X as well as the best linear


predictor of Y given X.s We will call (2.2.1) the direct regression. We can solve for
X in terms of Y as follows:

(2.2.3) x =--Ë.(å)" -(åþ

Now consider the best linear predictor of X given Y,

(2.2.4) BLPÍX IYJ = 1+ 0Y.

Call (2.2.4) the reverse regression. Take the expected value of X given the observed
value of Y:

E xlv E
-4,
p
.(;)" (t)''"1
(2.2.s)

å)" (r) r[elv]


-d .(
p

6
When the observed Y is treated as if it were generated by fixing X, applying a

linear transformation, and adding a mean zero disturbance term, the conditional
expection of that disturbance given the observed Y is equal to the unconditional
expectation:
E[elY]=Elel=0'

However, when X and Y are treated as a d¡aw from a bivariate probability


distribution, the conditional meary E[ e I Y], will, in general, be an increasing
function of Y. Since the best linear predictor, BLPÍX I Yl, is by definition the best
linear approximation to the conditional expectation function E[X I YJ, the slope of
the best linear predictor of X given Y will not equal the reciprocal of the parameter
multiplying X in the direct regression.6 In other words, the coefficient 0 from the
reverse regression of X on Y captures not just the direct impact of Y on X, which is
1

-p,but also the best linear approximation to the rate at which the expected value of
the error term, e, increases as Y increases. As a resulr, lå I > l0l, unless the error

terms are identically z,ero. In fact, the ratios !þ andfi,wt'rr,ch would equal one if
the direct and reverse best linear predictors wete identical, equal P2xy, the square of

the population correlation coefficient between X and Y.7


These results will carry over to the estimates produced by regressions on
samples. The direct sample regression of Y on X produces an unbiased estimate of
the parameter B; however, unless the regression fits perfectly, the reciprocal of that
parameter estimate does not equal the estimated slope of the best linear predictor of

X given Y (i.e., unless R2 equals or,., | * ô.¡ furthermore, the ratio of each slope
p
estimate to the reciprocal of the other is equal to R2. In the multivariate case, the
square of the relevant sample partial correlation coefficient equals the ratio of the
estimated slope in the direct regression to the reciprocal of the estimated slope in the

7
reverse regression.s These facts about the squared correlation coefficients will prove
useful later in interpreting estimates of Okun's coefficients in the literature.
How ought one to choose between the direct and the reverse regressions? For
purposes of understanding the economic relationship between two variables X and
Y, the parameter B in (2.2.1) may be the only coefficient of interest. The coefficient 0
reflects the presence of the eror term in the observed data, and the characteristics of

the errors may change from one population to another while the parameter B may
remain unchanged.
Ffowever, for purposes of prediction, when what is to be predicted is modeled

as a new draw from the original population, both p and 0 are relevant coefficients.

If, in the new draw, X is observed and Y is to be predicted, then sample estimates of
a and p from equation (2.2.1) can be used to produce an (unbiased) best linear
prediction of Y. \f , on the other hand, Y is observed and X is to be predicted, then
sample estimates of y and 0 from equation (2.2.4) should be used in order to obtain
the best linear prediction of X.
A classic example of this phenomenon is the distinction between permanent
income and current income. Suppose permanent income equals current income
plus transitory income and the expected value of transitory income conditional on
permanent income is identically zero. Then the best linear predictor (indeed, the
conditional expectation function) of curent income given permanent income is
just permanent income; the population regression slope is one. Flowever, in the
reverse regression the slope of the best linear predictor of permanent income given
current income is less than one because the expected value of transitory income
given current income is an increasing function of current income.9 The slope of
predicted permanent income given current income moves inversely to the variance
of transitory income. For pruposes of understanding the link between current
income and permanent income, the coefficient on permanent income in the direct
regression is fundamental. For purposes of predicting permanent income given

I
current income based on another draw from the same population, the coefficient on
current income in the reverse regression is essential.
Let us look at these issues in the context of the Okun's Law literature. Many
economists who have studied the relationship between unemployment and GNP
have mistakenly assumed that knowledge of a coefficient like B in the direct
regression
(2.2.6) /(u)=a+p/(GNP)
is sufficient for prediction of GNP given unemployment: all one need do is use the
reciprocal of the estimated value of B to predict what GNP would be at a given rate

of unemployment. The flaws in this approach applied to Okun's Law are first, that B

will vary with changes in structural parameters; second, it follows that to use
estimated values of B one must assume that the structure of the economy is
unchanged and, in that case, prediction of GNP given unemployment should be
based upon the reverse regression, which best predicts the mean value of GNP
given unemployment under economic conditions prevailing in the sample period.
Equation (2.2.6) ls relevant to answering the question: (1.) Given a certain
level of GNP, what level of unemployment should one expect under the economic
conditions prevailing during the sample period? However it is the wrong
regression for purposes of answering the question: (2) Given a certain level of
unemployment, what level of GNP should one expect under the economic
conditions prevailing during the sample period? To answer question (2) one must
run the reverse regression:
(2.2.7) /(GlrP) = y+ 0/(u).
Both questions (1) and (2) have been asked in the literature on Okun's law.
Unfortunately the literature has not.explicitly stated which regression is relevant for
which purpose. Furthermore, Okun and others have used the direct regression
(unemployment on GNP) to answer question (2), when they should have used the

I
reverse regression. In Section 3 we examine Okun's procedure and demonstrate
where he makes this error.
It may seem paradoxical that the slope of the relationship depends upon
which question is asked. Why should one, given an observed 2 percentage point
decrease in unemployment, predict a 4% faster than normal increase in GNP, while
one should, given an observed 4% faster than normal increase in GNP, predict only
a 1.33 percentage point decrease in unemployment? One way of answering the
puzzle is to observe that when unemployment falls by 2 percentage points, GNP on
average rises 4% faster than normal but when GNP rises 4% faster than normal, on
average unemployment falls by 1.33 percentage points. This phenomenon can be
observed in Figures L and 2 of this paper, below. The difference arises because when
one is predicting GNP, one is conditioning on knowledge of unemployment; when
one is predicting unemploymenÇ one is conditioning on knowledge of GNP. The
information on which the two predictions are conditioned is different and thus it
should not be surprising that the predictions are different.
Another way to address the paradox is to focus on the error terms which
stand for the linkage between GNP and unemployment. Observed higher than
average decreases in unemployment are, on average, only in part due to rapid rises
in GNP; on average, part of the decrease in unemployment should be attributed to
negative unobserved shocks in productivity and hours. Observed higher than
average increases in GNP are, on average, only in part due to exceptional decreases
in unemployment; on average, part of the extraordinary gain in GNP should be
attributed to positive unobserved shocks in productivity and hours.

10
3.0 A HISTORY OF OKUN'S LAW

3.1 Okun's Original Estimate


While at the Council of Economic Advisors during the Kennedy
Administration, Arthur Okun searched for a way to calculate potential ouþut and,
perhaps more important , for a relationship that would convince policy makers of
the extremely high cost of foregone ouþut from unemployment. An accurate
measure of potential output was needed for the activist, demand management role
Okun believed the government should play. After all, appropriate policy actions
can only be taken when the state of the economy relative to some ideal is known.1O
Okun realized, however, that skeptics would have to be convinced of the high cost
of laissez faire before they would accept aggressive demand management policies.
Thus, Okun's fundamental objective was to dramatize what he saw as the
tremendous waste of unemployed labor:

The evaluation of potential output can also help to point up the


enormous social cost of idle resources. If programs to lower
unemployment from 5llzto 4 percent of the labor [sic] are viewed as
attemþts io raise the economy'a "grade" from 941lzto 96, the case for
them may not seem compelling. Focus on the "gap" helps to remind
policy-makers of the large reward associated with such an
improvement. (Okun [19621, p. 98).11

The concept of potential output was imprecise and so was its


quantification. Yet it helped to deliver and dramatize the verdict that
idle resources were a major national exbavagance in the late fifties and
early sixties. (Okun Í79701, p.40).

Okun delivered a convincing argument of the high cost of unemployment by


using "thÍee methods of relating output to the employment rate" and a "subjective
weighting" of coefficient estimates to arrive at the familiar equation,
P = A[1 +.032(U-4)]

11
(where P=potential output, A=actual ouþut, and U=unemployment rate), that
embodied what came to be known as Okun's Law (Okun U962| p. 100).tz Okun's
equation determines potential ouþut and the foregone ouþut due to
unemployment simultaneously by answering the question: How much higher
would output be if unemployment were 4%? The "fact" that a one percentage point
increase in the unemployment rate was associated with an ouþut loss equal to 3.2%
of potential output or that percentage point changes in unemployment were linked
to roughly 3-fold changes in the rate of growth of output was used to generate a

potential output series and played a role in determining the direction and
magnitude of stabilization policy throughout the 1960s.
Unfortunately, Okun's procedure for predicting the rate of growth of output
associated with a given unemployment rate is incorrect. Assuming that a stable
relationship between output and unemployment exists over time (see Section 2.L),
Okun's procedure amounts to predicting output given full employment (assumed
to be an unemployment rate of 4%). This requires that output be regressed on
unemployment. In each of the three methods he proposed, however, Okun
regressed some measure of employment on a rate of growth of output variable, then
took the reciprocal of.the estimate of the slope to arrive at a quantitative measure of
the Okun Coefficient on Unemployment, i.e., the output loss associated with a

given deviation in the unemployment rate from full employment. Section 2.2
above has shown how this procedure systematically overestimates the absolute
value of the Okun Coefficient on Unemployment. Table 1 reports a replication of
Okun's original results and provides correct estimates of the Okun Coefficient on
Unemployment for his data:13

12
Table 1: Replicatins and Corectins Olrtur t1962t

Estimation Estimated Equation Reported Okun I lEstimated Equation Correct Okun


Coefficient on II Coefficient on
Method Unemployment Unemployment
ll
=V.30 =&3 1"95
Method 1: First ô
ÅU= 3 -.\VIA,Q "one percentage
Differences point more in the
(.04x.04) unemployment
rate means 3.37o
LsLTqa- $60Q4 less GNP" (Okun .4.
RÈ.58 D-W=1.6 [1962], p. 99) EotQ= 9t -L95
(.13) (.23) ^U
Ls47q2 1960Q4
R2=.58 D-W=2.0

Method 2: Trial .4. =U.ß*2Íl ._^ =W


U'= 3.67+.3óVo gap 'an increment of Vogap=$O +2.35U
Gaps unemployment of
(.14) (.03) (1.0) (.20)
one percent is
assoiiated with 1953Q1- 1960Q4
1953Q1- 1960Q4
an output loss
&L.82 D-TV=.49 equal to 2.8Vo of W=82 P-14r=.43
potential output"
(Okun [1962], p.
100)

.^ =U.ffitnU.40=2,8 .^ = 1.&3
Method 3: Fitted t0.2fi
Trend and lnE=212+.40 ln+321 lnQ='ZS+f.$ hE+.75t
Elasticity (27) (.04) (.03) "Fitted to varying (e2) (.20) (.03)
sample periods,
1953Q1- 1960Q4 ßl o" .35 to.40, 1953Q1- 1960Q4
RÈ.84 D-![=.54 suggesting that W=.97 D-W=.57
R2uPIoQ.t =.74 each one R2loQloP.t =.74
percentage point
reduction in
unemployment
means sliehtly
less tl¡an a 3
percent
increment in
output" (Okun
[1962],p.100)

Variahle definitions and data sources:


IJ = seasonally a{¡'usted quarterly unemployment rate; Bureau of Labor Statistics; published in Survey of
Current Business (Apr 1960, p.22, and Apr 1961, S-11).
E= 100-U.
Q = seasonally a{usted quarterly Gross National Product in billions of 1958 dollars; Dept. of Commerce;
published in Tlæ Nøtíonøl Incorne and Product Accounts of the Uníted States, 1929-1965,pp. 4õ.
t = time trend.
Vogap = (PotGNP - GNP) as percent of PotGNP where PotGNP is based on a3.5Vo trend line through the middle of
1955.

Arlrlitional Notest
Standard errors are given in parentheses below the coefficient estimates.
R2urue.t = the square of the partial co¡relation coeffrcient of lnQ and lnE given t.
Okun's mistake can be clearly shown by a replication of Chart 5 from The
American Economy in L961: Problems and Polícíes (in Tobin and Weidenbaum [L988],
p.27) where Okun's Fitted Line was included in the origirral, while the BLP of %Gap
given U has been added:

Figure 1: Relationship between Unused Potential GNP and Unemployment Rate:


Reciprocal versus Correct

ol un's Fitta I Line: L =3.67+.31 ToGap


Þl (slor ¡ - (U.35 - 2.9)

r .¿
Er
zH
E<

R a
k ,/
o
É{
zfi¡
()
'4,
a
BLP of 9 given U: VoGap = -$.9 ¡ 2.35U

É
f¡ì
Ê{
ü)
t:./ o

Ê{
(5 a
.2 F¡ a
o
to1

Þ{
zu 1/
,/
2 s4567 8
IINEMPLOYMENT RATE (PERCENT)

At most levels of the unemployment rate, Okun's fitted line (plotted by solving
lJ=3.67 + .35%gap for %gap as a function of U), gives a higher absolute value of the
%gap than the estimate given by the best linear predictor. As shown in Section 2
above, the degree of bias varies inversely to the correlation between U and %gap. Had
Okun presented the results of Method L (First Differences) in this manner, the much
less tightly scattered data (r=.76 versus r=.9L in Figure 1) would have immediately
revealed the poor fit of the line based on taking the inverse of ÂU=/(%Aq¡.ta
There is little doubt that Okun was aware that there are two regression lines.
Commenting on Perry's paper on potential output, Okun is reported to have said:

14
[My] original regressions, which sought to estimat" th9 ulemployment rate if
ouiput grew 1 percent faster than potential, gave a multiplier of around 3.2;
asking what output gain accompanied a one-point reduction in the
unemployment rate gave a multiplier of around 2.5 [in fact, it is closer to 2].
The difference comes because the correlations are not perfect . . . (General
Discussion of Perry Í197 Lbl, p. 5n -78).

Okun managed, however, to convince himself that regressing unemployment on


output and then taking the reciprocal of the coefficient estimate was appropriate. Two
factors apparently influenced Okun's decision. First, as a practical, political matter, he
wanted to show that lowering the unemployment rate resulted in large increases in
the rate of growth of GNP. In addition, Okun was persuaded by theoretical reasons for
choosing a measure of employment as the dependent variable:

Clearly, the estimates [of the ÂlnQ given a ÂlnE, in this Method 3 case] are
lower when output is regressed on employment. Kuh reported the same
phenomenon in "Measurement of Potential Output." The standard lagged
adjushnent model of labor demand espoused by Brechling and others cited
above would call for employment to be the dependent variable; I øm unaware
of øny analytícal model that points toward output as the dependent aøriable,"
(Okun [7973],p.273, footnote 8; emphasis added).

This reveals a confusion between estimating the parameters of a model and


finding the best predictor of a variable conditional on given information. Both output
and unemployment are endogenous variables to a complex system. Okun's Law was
presented and gained fame as an empirical regularity that tied these two variables
together. Okun's Law exploited the tight correlation between unemployment and
ouþut to predict one variable given the other. In this case, no "analytical model" is
needed to help us choose the dependent variable. The decision of how to run the
regression is completely determined by which variable one is interested in predicting.
The best linear predictor of the unemployment rate given output can be found by
regressing U on GNP (Okun's original approach); while any attempt to predict output
given unemployment requires that GNP be regressed on U. The fact that there are two
regression lines guarantees that taking the reciprocal of the slope will yield a biased

15
estimate of the best linear predictor.ls Thus, for the 53Q1 to 60Q4 sample period, the
best linear predictor of the rate of growth of output or the GNP gap given information
on unemployment has an estimated slope slope of roughly 2, not 3.2 as reported by
Okun.
This overestimate had important consequences on the policy target and, as a

result, on aggregate demand policy prescriptions. Since the Okun Coefficient was a
building block of the official potential GNP series, an overestimated Okun Coefficient
implied overstated potential ouþut (when unemployment was above 4%\ which, in
turn, might have led to inappropriate policy moves. Throughout the 60s and 70s, the
CEA reported a potential ouþut series that was based on finding the trend rate of
growth of potential GNP and then constructing the series by simply applying the trend
to a given benchmark. Unfortunately, the CEA never explicitly stated how the trend
rate of growth was determined. We believe that the CEA had no established, clear
algorithm for computing the official, hend-based potential GNP series. Information
on rates of growth of productivity, hours, and labor force participation rates, along
with potential GNP adjusted for unemployment (per Okun's Law) was, somehow,
combined to form a single estimate of the trend rate of growth of potential GNP.16
What is clear, however, is that to the extent that the CEA relied on potential GNP
derived from an Okun Coefficient of 3.2, they overestimated potential GNP when the
unemployment rate was above 4%. The importance of the role played by the
overstatement of potential GNP in swaying Congress to pass the fiscal stimulus
contained in the Revenue Act of 1964 (the Kennedy tax cut) is unknown.lT It cannot be
doubted, however, that the CEA's official potential output series helped convince
hesitant policy makers to act and determined the magnitude of the tax cut. Walter
Heller and other members of the CEA pressed for aggressive fiscal policies during
Congressional testimony in October of 1963:

These estimates [of potentiat GNP] show that the gap between actual GNP and
potential GNP at 4-percent unemployment has been substantial in every year
since 7957. In both 1962 and 1963, it has approximated $30 billion . . . The basic

16
purpose of the tax cut is to close that $30 billion gap . . . The process by which
an $11.1 billion tax cut can add as much as $30 billion to total demand has
.
been frequently described . . (Economic Report of the Presídent 119641, p. 171)

Thus, we conclude that Okun's overstatement of the effect of changes in the


unemployment rate on the rate of growth of ouþut was important because it
generated upward bias in the potential GNP series that was used as a target by policy
makers in the 1960s. In addition, Okun's mistaken procedure þased on taking the
reciprocal of the coefficient estimate) has influenced the economics literature up to the
present time.

3.2 Okun's Law in the 60s.70s and 80s


By the 1970s, the literature on Okun's law had taken several divergent paths.
Although everyone agreed that Okun's Law was a rough approximation that
performed better during certain periods than others, economists differed on how to
improve the accuracy of the prediction. It is surprising that no one realized that the
bias created by taking the reciprocal of the coefficient was a primary cause of the poor
performance of Okun's Law when the correlation between output and unemployment
was low. Instead, efforts were focused on breaking down the relationship between
output and unemployment into its component parts or better estimating the
relationship.
Denison (1L9741, [1979), and [1985]) maintained that, although Okun's procedure for
estimating potential output was preferable to a simplistic trend approach, it was
inadequate. Denison's major substantive criticism of the estimates derived from
Okun's Law was that it overestimated the absolute value of the gap between actual and
potential GNP. Denison advocated a components approach or "sources of growth
analysis" and showed how this method yielded much smaller estimates of potential
GNP than those reported by the CEA. Although Denison concluded that Okun's law
suffered from "insufficient specification" and was "simply much too crude and
suûunary a procedure to yield good results" (Denison, U9741, p. 86), it is interesting to

t7
point out that an Okun coefficient of 2.0 (instead of the original 3.2) greatly lowers the
divergence between Okun's rule of thumb estimate and Denison's potential output
series. Kuh [1965], Thurow and Taylor Í19661, and Black and Russell [1969] also
attempted to analyze the comPonent parts of potential GNP.
Others, remaining faithft¡l to Okun's original approach, tried to better estimate the
relationship between ouþut and employment. Perry ll971bl introduced the use of a
"constant weighted unemployment rate" in order to account for increased proportions
of women and teenagers in the labor force. A variety of models using various lengths
of lagged ouþut as an additional independent variable were inhoduced (see, for
example, Tatom Í1978)). Finally, many tried alternative specifications, corrections for
autocorrelation, and more powerful estimation techniques. Notwithstanding these
improvements and modifications, prediction of percentage changes in output, the
GNP gap, and potential output given unemployment continued to be at least partially
based incorectly on an Okun coefficient that was the reciprocal of the parameter
- -
estimate of unemployment regressed on output.

4.0 OKUN'S LAW TODAY


In 1962, Okun used the wrong regression line to predict the foregone ouþut given
a deviation in the unemployment rate from the full employment level and to
calculate the GNP gap and potential GNP. But his error is far from a matter of mere
historical interest, for the same mistake continues unabated to the present day. We
present, in this section, an outstanding example of the consequences of running the
incorrect regression drawn from the contemporary literature.
Hamada and Kurosaka [1984] (including comments by Mairesse [1984] and Haraf
[1984]), Kaufman [1988], and Tachibanaki and Sakurai [1991] have all found extremely
large Okun Coefficients on Unemployment for the ]apanese economy. Hamada and
Kurosaka ([1984], p.n) report a value oÍ 32.4 for the years 1965-7974; while Tachibanaki
and Sakurai (19911, p. 1584) claim that adjustments in the unemployment measure

lfì
lower Okun coefficients "by about 40-50 percent" (from, e.g., 67.6 to 40.2). Although
these authors use a variety of schemes (including: correcting for autocorrelation,
different specifications, varying lag lengths, estimating within subperiods, and
adjustments to the unemployment variable) in order to lower the Okun Coefficient on
Unemployment to more plausible levels, all fail to recognize that they severely
overestimate the predicted output given unemployment when they use the reciprocal
of the coefficient from the wrong regression.
Due to a lack of data, we were unable to replicate particular regressions; however,
a single, simple example makes it clear that regressing unemployment on output and
then taking the reciprocal of the coefficient estimate causes very large overestimates of
the Okun Coefficient on Unemployment. Applying Okun's Method L, First
Differences, to the Japanese economy from 1953 to 1982 yields the following:

Table 2: The Direct versus Reverse Regression in fapan.1953-1982

Ouestion Estimated Equation


a
ÂU = .2ßL -.0327o¡GNP
(1) given %^GNP
^U (.078) (.ooe)

R2 =.30
.. .^
7.77 -9.4ß L:,U
^øGNP'=
(2) %^GNP given ÂU (.seo) Q.n)
R2 =.30

Variable definitions and data sources:

g = yearly unemployment rate; Hamada and Kurosaka [1984], Table 1, p.73.


'/"^GNP - yearly rate of real GNP growtlç Hamada and Kurosaka [1984], Table
7, p.73.

Standard errors are given in parentheses below the coefficient estimates.

19
The reciprocal of the coefficient on %ÅGNP from ¡V=f (%LGNP), i.e., what is
commonly reported as the "Okun coefficient," is approúmately -3L and can be
interpreted as the predicted percentage change in GNP given a percentage point
movement in change in unemployment. In fact, as Figure 2 clearly reveals, the best
linear prediction of the %^GNP gíven a one percentage point change in is -9.46.
^U

Figure 2: Predicting %AGNP given ÂU for lapan: Reciprocal versus Correct

15 a
t
a

\ t
10 \ O

dt
a \ oa
Êr
z
u 5
N-.
-\
l\(
\ BLP of %^GNP
èQ
r53-19t
given ÂU
0 4 \
a
\ ction of %ÂGNP given
based on reciprocal
-5
-0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6

ÅUnem

The cause of the large degree of overestimation found when the reciprocal of B
(from the regression of ÀU on %^GNP) is taken as a measure of 0 is the low
correlation between output and unemployment in the ]apanese economy during
the time period under analysis. There is no need to explore a wide variety of
alternative answers to the "pvzzIe" of an extremely high Okun coefficient in ]apan
the exEemely large value is merely a statistical artifact.
-
This is not to say, however, that the ]apanese case is uninteresting. The above
cited authors advance plausible reasons why the ]apanese economy is different from
the US economy; there is little doubt that these differences are worth exploring. Of

n
course, we should be sure that we are focusing on real factors and not statistical
illusions. The Japanese undoubtedly have a larger Okun Coefficient on
Unemployment than the United States, but the difference in magnitude is nowhere
near what has been reported.

s.0 coNclusroN
In 1983, Lester Thurow wrote that "As America's productivity growth rate fell
[during the 1970s,] Okun's Law gradually became less and less accurate until it was
dropped as a tool of analysis entirely." (Thurow,l1983l, p.9). This paper shows that
one of the key reasons for the deteriorating accuracy is the continued use of an
incorrect procedure, i.e., running a regression of unemployment on output, then
taking the reciprocal of the estimate in order to answer questions concerning the
responsiveness of ouþut given changes in unemployment. Thus, the Okun
Coefficient on Unemployment has changed, but not from 3 to 2.5 or 2 (as reported in
various macro textbooks): Furthermore, in any environment with low correlation
between unemployment and ouþut such as that in ]apan, Okun's incorrect
methodology results in large overestimation of the true effect of unemployment on
outPut.18
Blackley 11991.,p.64U noted that:

Okun's law has been used (1) as a parameter ín formulas which calculate
potential GNP, (2) as a way to measure the opportunity cost in foregone
output of unemployment when it exceeds its natural, full employment rate,
and (3) in econometric models to forecast unemployment in response to
anticipated changes in real GNP.

Assuming that regression is appropriate (an issue too often ignored), the choice of
direction plays a key role in correct estimation. We have argued here that the
choice of direct versus reverse regression depends upon the question one is asking.
For questions (1) and (2), regressions of output on unemployment are appropriate;
for question (3), regressions of unemployment on output are correct.

2L
With respect to Okun's Law, there is no doubt that the correct model is a
simultaneous system in which ouþut and unemployment are endogenous. This
paper shows that a rough rule of thumb, single equation model can be fruitfully
employed only if the regression line is thought of as a best linear predictor and run
in the correct direction for the question at hand. In the Okun's Law literature, the
wrong regression has generated much confusion and severe overestimation of the
relevant parameters.

n
ENDNOTES

L This fundamental statistical point has been made twice before in the Okun's
Law literature: first by Summers [1968] and then (apparently independently) by
Plosser and Schw eft [19791. Unfortunately, these papers have remained almost
completely unnoticed. An extensive literatu¡e search revealed three citations:
Perloff and Wachte{s fl979a, t9:Tgblcitations of Summers [1968] and Wulwick
[1991] and Nelson's [1982] acknowledgement of Plosser and Schwert [1979]. Our
paper explores the statistical issues involved in the particular application to
Okun's original work in much greater depth than Summers or Plosser and
Schwert. We thank Iotrn Tatom for bringing Summers's work to our attention.

2. In this paper, we differentiate between the Okun Coefficient on Unemployment


(from output regressed on unemployment) and the Okun Coefficient on Output
(from unemployment regressed on output). As we explain below, these
coefficients provide answers to two different, but equally valid, questions.

3. As stated in footnote 1, above, the exceptions are Summers (1968) and Plosser
and Schwefi, (1979).

4. Maddala $9n) has discussed in general terms the differences between these
two approaches. He calls the first type of procedure, "least-squares regression"
and the second Wpe, "bivariate regression."

5. In a population, the best linear predictor minimizes the expected value of the
square of the prediction error. The sample estimator of the best linear predictor
is the ordinary least squares regression.

n
6. Summers (1963) uses examples to show that the conditional expectation
function of X given Y depends uPon the marginal distribution of Y; in
particular, the conditional expectation function of X given Y need not be linear
even if the conditional expectation function of Y given X is linear.

7. This can be easily shown by substituting for p and 0 using the formulas for the
best linear predictors (the population linear projections) of Y conditional on X

and X conditional on Y, respectively, and forming the ratios 1/B


0
ud#
8. Malinvaud [1980] demonsbates this on pp. 8-9. See also pp. 27-3L for discussion
via an example of the multivariate case.

9. See exercises 5.3 and 5.4 in Goldberger [1991], PP. 55-56.

10. The CEA wrote in 1963 that


"The potential GNP of the U.S. economy measures the
volume of goods and services that our economy could
produce if the unemployment rate were at the interim
target of 4 percent. Potential GNP cannot actually be
observed when unemployment is above 4 percent; and to
estimate it ís an inherently difficult task. Even the best use
of available data and of statistical and economic techniques
will leave a margin of enor in the calculation.
Nevertheless, decisions on policies to stimulate or restrain
the over-all level of economic activity require a judgment
on the gap between current and potential production."
(Economíc Report of the President ll963i, p. 81).

1.1,. This remark was undoubtedly directed at Ted Sorenson (Kennedy's closest
advisor on domestic policy) who "wondered why raising the employment score
from 93 to 96 percent,'A minus to A,' deserved high political priority." (Tobin
and Weidenbaum [1988], p. 9).

ZL
6. Summers (1968) uses examples to show that the conditional expectation
ftrnction of X given Y depends upon the marginal distribution of Y; in
particular, the conditional expectation function of X given Y need not be linear
even if the conditional expectation function of Y given X is linear.

7. This can be easily shown by substituting for p and 0 using the formulas for the
best linear predictors (the population linear projections) of Y conditional on X

and X cond.itional on Y, respectively, and forming the ratios LU


fr ^"O r.
8. Malinvaud [1980] demonstrates this on pp. 8-9. See also pp. 27-31, for discussion
via an example of the multivariate case.

9. See exercises 5.3 and 5.4 in Goldberger [1991], pp. 55-56.


10. The CEA wrote in 1963 that
"The potential GNP of the U.S. economy measures the
volume of goods and services that our economy could
produce if the unemployment rate were at the interim
target of.4 percent. Potential GNP cannot actually be
observed when unemployment is above 4 percent; and to
estimate it is an inherently difficult task. Even the best use
of available data and of statistical and economic techniques
will leave a margin of error in the calculation.
Nevertheless, decisions on policies to stimulate or restrain
the over-all level of economic activity require a judgment
on the gap between current and potential production."
(Economíc REort of the President 179631, p. 81).

11. This remark was undoubtedly directed at Ted Sorenson (Kennedy's closest
advisor on domestic policy) who "woirdered why raising the employment score
from 93 to 96 percent,'A minus to A,'deserved high political priority." (Tobin
and Weidenbaum [1988], p. 9).

2tL
L2. Although not presented as sucþ Okun's three methods can be traced to a
common implicit relation. Assume that ouþut (Q) at time t is related to
unemployment (U) as follows:
Q¡,= Q6ec+FGI¡.0a)*Tt

Taking the natural log, first differencing, and rewriting in terms of ÅU1 yields
Method L; taking the natural log and rewriting as ln(Q¡lQoeTt) = (o -.048) + FUt
results in Method 2; and taking the natural 1og, rewriting in terms of U¡, and
substituting Et = 100-Ut produces Method 3. Methods L and 3 estimate Y, the
growth rate of potential output, simultaneously (using differences and levels,
respectively), while Method 2 estimates T separately using levels. In addition, his
"subjective weighting" of estimates derived from each method clearly favored
Method 1 (First Differences) for his Okun Coeffícient on Unemployment of 3.2
relies most on the 3.3 value of the first method (see Table 1).

1.3. Absolutely exact replication was not achieved because Okun's output variable was
CEA-generated, but never published, quarterly GNP data in L960 prices. The
series Okun used was constructed by converting major components of GNP in
1954 prices by using the implicit price indexes for each component (Economic
Report of the President 119621, p.209 and Tobin and Weidenbaum [1988], p. 26).
The CEA notes tþat "it would have been preferable to redeflate the series by
minor components" (Economíc Report of the Presídent 119627, p.209). Our use of
quarterly GNP in 1958 prices results in slight differences in Method2, where
Okun reported the following:
U =3.72+.36Gap (r=.93).

14. See Section 4 below, especially Figure 2.

15. For example, the best linear prediction of unemployment given a 6Y" GNP gap
would be U = 3.67 + .35(6%) = 5.77o/o. Solving 6o/o = -8.0 + 2.35U for U
(= 5.96%) yields a biased prediction. Similarly, the best linear prediction of the
GNP gap given an unemployment rate of 7% wouldbe calculated as %gap
= -8.0 + 2.35(7%) = 8.45%. Okun's procedure, solving 7o/o = 3.67 + .3ío/ogap, for
%gap F 9.5L%) overestimates the true gap. If this estimate of the GNP gap is then
used to calculate potential output via the relationship

%
(A\
p= t-l 100
- %sap
\too J
overestimating the GNP gap leads to ove¡estimating potential GNP.

1.6. Perry reported that "The ingredients of the official estimate [of potential GNP] are
unclear." (Perry, p.5n V97lbl). He also remarked in a phone conversation
(August 18, t992) that, to the best of his recollectiory "No fixed procedure was
used to determine the trend rate of growth of potential GNP."

17. Solow and Tobin believe the primary impetus had nothing to do with economics:
Indeed even the tax cut made it through Congress only on the
wave of sentiment that followed Kennedy's assassination in
November 1963. (Tobin and Weidenbaum [1988], p. 11).

18. Italy and Sweden also have very low correlations between measured
unemployment and output. And see the state of Louisiana in Blackley U9911
Table 2,p.646.

%
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29

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