Okun's Law

Dr. Namrata Anand

Assistant Professor
What Is Okun's Law
 Okun's Law is an empirically observed relationship
between unemployment and losses in a country's
production. When economists are studying the economy,
they tend to hone in on two factors: output and jobs.
Because there is a relationship between these two
elements of an economy, many economists study the
relationship between output (or more specifically, gross
domestic product, GDP) and unemployment levels. 
 Okun's Law looks at the statistical relationship between
GDP and unemployment. Okun's Law can also be used to
estimate gross national product (GNP).
Understanding Okun's Law
 Arthur Okun was a Yale professor and an economist who studied
the relationship between unemployment and production. Okun
was born in November 1928 and died in March 1980 at the age of
51. He studied economics at Columbia University, where he
received his Ph.D. During his tenure at Yale, Okun was appointed
to President John Kennedy's Council of Economic Advisors. He
remained in this position under President Lyndon B. Johnson as
well.
 As a Keynesian economist, Okun advocated for using fiscal policy
to control inflation and stimulate employment. He first proposed
the relationship between unemployment and a country's GDP in
the 1960s. In general, Okun's findings demonstrated that when
unemployment falls, the production of a country will increase.
Cont….

 Many years later, the Federal Reserve Bank of St. Louis has defined
Okun's Law like this: "[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." The logic is fairly
straightforward. The amount of output that an economy produces
depends on the amount of labor (or the number of people employed)
in the production process; when there is more labor involved in the
production process, there is more output (and vice versa).
 In Okun's original statement of his law, an economy experiences a 1
percentage point increase in unemployment for every 3 percentage
point decrease GDP from its long-run level (also called potential
GDP). Similarly, a 3 percentage point increase in GDP from its long-
run level is associated with a 1 percentage point decrease in
unemployment. Potential GDP is the level of output that can be
achieved when all resources (land, labor, capital, and entrepreneurial
ability) are fully employed.
Cont….

 However, Okun's Law might be better characterized as a "rule of thumb"

because it is based on empirical observation of data, rather than a
conclusion derived from a theoretical prediction. Okun's Law is an
approximation because there are other factors, aside from employment,
that impact output, such as capacity utilization and hours worked. This
also explains why there isn't a one-to-one relationship between changes in
output and changes in unemployment.
 For example, Okun also estimated that a 3 percentage point increase in
GDP from its long-run level corresponded to a 0.5 percentage point
increase in the labor force participation rate, a 0.5 percentage point
increase in hours worked per employee, and a 1 percentage point increase
in labor productivity (output per worker per hour). This would leave the
remaining 1 percentage point to be the change in the unemployment rate.
 The relationship between unemployment and GDP (or GNP) varies by
country. In industrialized nations with labor markets that are less flexible
than those of the United States, such as France and Germany, the same
percentage change in GNP has a smaller effect on the unemployment rate
than it does in the United States.
Does Okun’s Law Hold True?
 While Okun's Law has proven to be true at certain times throughout history, there
have also been conditions where it has not held true. The Federal Reserve Bank of
Kansas City conducted a review of Okun's Law by looking at quarterly changes in
unemployment and comparing that data to quarterly growth in real output.
 The study also examined different versions
 According to their findings, Okun's Law was accurate.
 In fact, the study concluded that “Okun’s law is not a tight relationship,” but that it
“predicts that growth slowdowns typically coincide with rising unemployment.”
 The percentage increase by which GNP changes when unemployment falls by 1%
is the Okun coefficient.
 In the United States, the Okun coefficient estimates that when unemployment falls
by 1%, GNP will rise by 3% and GDP will rise by 2%. When unemployment rises
by 1%, then GNP is expected to fall by 3% and GDP is expected to fall by 2%.
Shortfalls of Okun's Law
 While economists broadly support Okun's law, it is not considered to be
wholly accurate. Economists support an inverse relationship between
unemployment and production, believing that when unemployment
rises, GNP and GDP will simultaneously fall, and when unemployment
declines, GNP and GDP are expected to increase. However, the exact
amount varies. 
 Further studies on the relationship of unemployment to production
include a broader set of labor market variables are necessary to analyze
the effects of the labor market on GNP and GDP. These variables
include the level of the total labor market, hours worked by employed
workers and productivity levels for workers. Under further analysis,
economists have found the change in production for every 1% change in
unemployment to vary with more volatility than Okun's law sets forth.