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).
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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.
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.
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.