Q. Briefly explain Okun's Law.

Why should economists care about inflation and

unemployment?

Answer:

Introduction of Okun:

He was Yale professor and economist. His full name was Arthur Okun and he was born in November
1928 and died in March 1980 at the age of 51. He first published his findings on the subject in the early
1960s, which have since come to be known as his “law.”

Okun’s Law: the Basics:

In its most basic form, Okun’s law investigates the statistical relationship between a country’s
unemployment rate and the growth rate of its economy. The economics research arm of the Federal
Reserve Bank of St. Louis explains that Okun’s law “is intended to tell us how much of a country’s gross
domestic product (GDP) may be lost when the unemployment rate is above its natural rate.” It goes on to
explain that “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 relationship between output and employment. Total employment
equals the labor force minus the unemployed, so there is a negative relationship between output and
unemployment (conditional on the labor force).”

Total employment= Labor Force – unemployed

This law is known for its simplicity and accuracy. However, a lot of doubts have been raised on this law
as it does not hold fit in every state for every economy. To make it clear, in an economy that is
industrialized and has strong labor markets, the percentage change in GDP will have less effect on the
unemployment rate.

UNDERSTANDING THE NEGATIVE RELATIONSHIP:

 Originally Okun stated that the economy experienced a 1 percentage point increase in
unemployment for every 3 percentage point decrease in actual GDP.
 In order to understand why the relationship between unemployment and output is not one to one,
it’s important to keep associated factors in mind such as.
  Changes in the number of hours worked per person.
 Changes in labor productivity.

Okun’s Law Formula:

Okun’s law is given by the following formula:

Okun's Law Formula

Where:

y = Actual GDP

y* = Potential GDP

β = Okun Coefficient

u = Unemployment rate of the current year

u* = Unemployment rate of the previous year

y-y* = Output Gap

So, the output gap (the difference between Actual GDP and Potential GDP) divided by Potential GDP is
equal to the negative Okun coefficient (negative represents the inverse relationship between
unemployment and GDP) multiplied by the change in Unemployment.

Okun’s Law explanation in the case of Pakistan:

Year GDP Growth Rate Unemployment Rate

2019 0.99% 4.45%
2018 5.84% 4.08%
2017 5.55% 3.95%
2016 5.53% 3.79%
 2015 4.73% 3.57%
2014 4.67% 1.83%
2013 4.40% 2.95%
2012 3.51% 1.70%
2011 2.75% 0.80%
2010 1.61% 0.65%
2009 2.83% 0.54%
2008 1.70% 0.42%
2007 4.83% 0.40%
2006 5.90% 0.58%
2005 6.52% 0.61%
2004 7.55% 0.63%
2003 5.78% 0.64%
2002 2.51% 0.64%
2001 3.55% 0.63%
2000 4.26% 0.63%
8.00%
7.00%
6.00%
5.00%
4.00%
GDP Growth Rate
3.00% Unemployment
Rate
2.00%
1.00%
0.00%

Graphical analysis to further explain the relationship may it be positive or negative. Although we know
that this law implies in industrial countries but we can check it for Pakistan and we can analyze that it has
positive relationship as Unemployment rate increase from 2015 to 2019 than GDP also decreases.
Remaining it has positive relation as GDP increases with decrease in Unemployment rate.

How Inflation and Unemployment Are Related:

The relationship between inflation and unemployment has traditionally been an inverse correlation.
However, this relationship is more complicated than it appears at first glance, and it has broken down on a
number of occasions over the past 50 years.
Since inflation and employment (and unemployment) are some of the most closely monitored economic
indicators, we'll delve into their relationship and how they affect the overall economy.

Labor Supply and Demand:

When unemployment is high, the number of people looking for work significantly exceeds the number of
jobs available. In other words, the supply of labor is greater than the demand for it.

In times of low unemployment, the demand for labor by employers exceeds the supply. In such a tight
labor market, employers typically need to pay higher wages to attract employees, ultimately leading to
rising wage inflation.

Why should economists care about inflation and unemployment?

Over the years, economists have studied the relationship between unemployment and wage inflation, as
well as the overall inflation rate.

In general, economists have found that when the unemployment rate drops below a certain level, referred
to as the natural rate, the inflation rate will tend to increase and continue to rise until the unemployment
rate returns to its natural rate. Alternatively, when the unemployment rate rises above the natural rate, the
inflation rate will tend to decelerate.

The natural rate of unemployment is the level of unemployment consistent with sustainable economic
growth. An unemployment rate below the natural rate suggests that the economy is growing faster than its
maximum sustainable rate, which places upward pressure on wages and prices in general leading to
increased inflation. The opposite is true if the unemployment rate rises above the natural rate, downward
pressure is placed on wages and prices in general leading to decreased inflation. Wages make up a
significant portion of the costs of goods and services, therefore upward or downward pressure on wages
pushes average prices in the same direction.

Economists care about unemployment for two reasons:

1) Unemployment has important social consequences.

2) The unemployment rate gives them an indication of whether an economy is operating above or
below its normal level of activity.