Academic journal article Federal Reserve Bank of St. Louis Review

Okun's Law over the Business Cycle: Was the Great Recession All That Different?

Academic journal article Federal Reserve Bank of St. Louis Review

Okun's Law over the Business Cycle: Was the Great Recession All That Different?

Article excerpt

In 1962, Arthur Okun posited an empirical relationship between the change in the unemployment rate and real output growth. Since then, the media, policymakers, pundits, and intermediate macro students have used the so-called Okun's law as a rule of thumb to relate changes in unemployment to changes in output growth. However, some studies have suggested that the relationship has not been stable over time. Furthermore, the slow recovery of U.S. unemployment relative to output after the Great Recession has led some to question whether Okun's law has changed permanently. In this light, the authors reconsider the evidence on instability in Okun's law and, in particular, examine whether the Great Recession has contributed to the breakdown of the empirical relationship. (JEL C22, E32)

Federal Reserve Bank of St. Louis Review, September/October 2012, 94(5), pp. 399-418.

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Many macroeconomic textbooks contain a rule of thumb relating real output growth to changes in the unemployment rate. l This relationship, called Okun's law after Okun (1962), typically assigns a 2- to 3-percentage-point decrease in real gross domestic product (GDP) growth to a 1-percentage-point increase in the unemployment rate. (2) Unlike laws in the physical sciences (e.g., Newton's laws of motion), Okun's law is an (arguably loose) empirical correlation and is, in general, neither theoretically motivated nor strictly adhered to in the data. (3) As many of the reduced-form relationships build strictly on associations and not causation, Okun's law appears to vary depending on the sample period studied.

The recent economic experience in the United States following the Great Recession (2007:Q4-2009:Q2) has prompted considerable doubts about the nature of Okun's law. In particular, during the recovery from the Great Recession, the United States has experienced a sustained high level of unemployment during a period of positive output growth, which is symptomatic of so-called jobless recoveries. Thus, there have been concerns in policy circles that the apparent correlation between different measures of unemployment and output fluctuations has weakened over time. We take a closer look at the past three recessions when the jobless recovery phenomenon was documented as more prevalent (see Engemann and Owyang, 2010). In addition, we investigate whether the correlation between unemployment and output fluctuations has been significantly different during the Great Recession and the follow-up recovery. Furthermore, some interesting differences in the behavior of Okun's law are apparent if unemployment rates for specific demographic groups are studied; we allude to some of these differences.

The balance of the paper is organized as follows: The next section reviews the history of Okun's law, including alternative representations and some criticisms. In the following section, we posit three alternative representations of Okun's law that allow for shifts in the relationship across the business cycle. We then consider the empirical evidence, which is followed by our conclusion.

OKUN'S LAW

Okun's (1962) seminal paper regarding the unemployment-output relationship considers the measurement of potential output. Okun believed that the potential output should not be defined as the maximum output the economy could (unconditionally) produce. Instead, he argued that the potential should be measured at full employment, which he characterized as the level of employment absent inflationary pressures, or the level of the non-accelerating rate of unemployment (NAIRU). (4) Consequently, at the business cycle frequency the deviations of unemployment from a level such as the NAIRU could be correlated with the deviations of output from its trend.

Using quarterly data from 1947:Q2 to 1960:Q4, Okun regressed changes in the unemployment rate on changes in the log of real gross national product (GNP):

(1) [DELTA][u. …

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