Academic journal article Economic Review - Federal Reserve Bank of Kansas City

How Useful Is Okun's Law?

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

How Useful Is Okun's Law?

Article excerpt

(ProQuest: ... denotes formulae omitted.)

From the beginning of 2003 dirough the first quarter of 2006, real gross domestic product in the United States grew at an average annual rate of 3.4 percent. As expected, unemployment during the period fell. Over the course of the next year, average growth slowed to less than half its earlier rate-but unemployment continued to drift downward. This situation presented a puzzle for policymakers and economists, who expected the unemployment rate to increase as the economy slowed.

Typically, growth slowdowns coincide with rising unemployment. This negative correlation between GDP growth and unemployment has been named "Okun's law," after the economist Arthur Okun who first documented it in the early 1960s. Part of the enduring appeal of Okun's law is its simplicity, since it involves two important macroeconomic variables. Additionally, the relationship appears to enjoy empirical support. In reality, though, Okun's law is a statistical relationship rather than a structural feature of the economy. As with any statistical relationship, it may be subject to revisions in an ever-changing macro economy.

This article considers the usefulness of Okun's law for policymakers and economists. It focuses on two questions. First, is Okun's law a reliable, stable relationship? Second, is the law a useful forecasting tool?

The evidence suggests that Okun's relationship between changes in the unemployment rate and output growth has varied considerably over time and over the business cycle. Nevertheless, Okun's relationship can still be useful as a forecasting tool-provided that one takes its instability into account.

The first section of this article examines the relationships first proposed by Okun. It also reviews the different versions of these relationships, which collectively are called Okun's law. The second section shows how the relationship between changes in unemployment and output growth has varied over time. The third section suggests two explanations for this variation. The fourth section considers how several different versions of Okun's law perform as forecasting tools.

I. WHAT IS OKUN'S LAW?

In his 1962 article, Okun presented two empirical relationships connecting the rate of unemployment to real output, which have become associated with his name.1 Bom were simple equations that have been used as rules of thumb since that time. In addition, both have been expanded on by economists to include elements that Okun omitted in his analysis. This section begins by describing the relationships that are commonly known as Okun's law. Okun's original estimates are then compared with estimates using a longer history of data.

Alternative versions of Okun's law

Okun's two relationships arise from the observation that more labor is typically required to produce more goods and services within an economy. More labor can come through a variety of forms, such as having employees work longer hours or hiring more workers. To simplify the analysis, Okun assumed that the unemployment rate can serve as a useful summary of the amount of labor being used in the economy.

The difference version. Okun's first relationship captured how changes in the unemployment rate from one quarter to the next moved with quarterly growth in real output. It took the form:

Change in the unemployment rate = a + b* (Real output growth). This relationship can be called the difference version of Okun's law. It captures the contemporaneous correlation between output growth and movements in unemployment-that is, how output growth varies simultaneously with changes in the unemployment rate. The parameter b is often called "Okun's coefficient." One would expect Okun's coefficient to be negative, so that rapid output growth is associated with a falling unemployment rate, and slow or negative output growth is associated with a rising unemployment rate. The ratio "-a/b" gives the rate of output growth consistent with a stable unemployment rate, or how quickly the economy would typically need to grow to maintain a given level of unemployment. …

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