DEFINITION of Okun Gap

Okun Gap  is a macroeconomic term that describes the situation when an economy's potential gross domestic product (GDP) differs from its actual gross domestic product. The gap can either be recessionary or inflationary, but will depend on the economy's current state, including levels of inflation and the unemployment rate.

BREAKING DOWN Okun Gap

An Okun gap can be expressed in either percentage or absolute terms and will be a measure of how much output, as measured by GDP, the economy produced in a given time period relative to the economy's full-employment level.

Arthur Okun, who is the person credited with discovering Okun's law, among other famous discoveries, was a senior economist at the Council of Economic Advisers (CEA) during President Kennedy's term in office and a professor at Yale University.

How Okun's law Works

Okun determined that a one percentage point higher unemployment rate correlated with 3% lower GDP, meaning that if unemployment was, say, 2 points above full employment, GDP would be 6 percent below its potential level. That gap translates to hundreds of billions of dollars in foregone revenue. In the years since he came up with this formula, the gap has drifted down to 2%, some economists contend.

There have also been periods where Okun's law hasn't worked well at all, such as during the financial crisis of 2008 and the 1970s, when inflation and stagflation wreaked havoc with employment and the economy as manufacturing jobs disappeared.

Still, a consistently large GDP gap can cause severe consequences on a country's economy – especially the labor market, long-term economic potential and the country's public finances. And the longer a GDP gap lasts, the longer the labor market will underperform.

A large GDP gap can lead to a struggling overall economy with a weak labor market and lost tax revenues, as unemployed or underemployed workers pay little or no income taxes, or at least less than they would have if fully employed. Additionally, a higher incidence of unemployment increases public spending on social safety-net programs. Reduced tax revenue and increased public spending both exacerbate budget deficits.

Despite some periods of disconnect, Okun's law has held up reasonably well over the decades. A Kansas City Fed study concluded that "Okun's law is not a tight relationship," but that "Okun's law predicts that growth slowdowns typically coincide with rising unemployment." Regarding the fact it did not hold up that well during the financial crisis, former Fed Chairman Ben Bernanke speculated that "the apparent failure of Okun's law could reflect, in part, statistical noise."