What is Okun's Law
Okun's law pertains to the relationship between the U.S. economy's unemployment rate and its gross national product (GNP). It states that when unemployment falls by 1%, GNP rises by 3%. However, the law only holds true for the U.S. economy and only applies when the unemployment rate is between 3% and 7.5%.
BREAKING DOWN Okun's Law
Okun's law can also pertain to how a rise in unemployment affects gross domestic product (GDP), where a percentage increase in unemployment causes a 2% fall in GDP.
Arthur Okun was a Yale professor and economist who studied the relationship between unemployment and production. He first published his research on the topic in the 1960s, and his findings were established as Okun’s law. It provides a general notion construing that when unemployment falls, the production of a country will increase. This measure can be used for estimating both GNP and GDP.
The percentage increase by which GNP changes when unemployment falls by 1% is the Okun coefficient.
The relationship between unemployment and GNP or GDP varies by country. 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%.
Industrialized nations with labor markets that are less flexible than those of the United States, such as France and Germany, tend to have higher Okun coefficients. In those countries, the same percentage change in GNP has a smaller effect on the unemployment rate than it does in the United States.
Okun's Law Shortfalls
Economists broadly support Okun's law, but it's considered to be inaccurate. This comes as numerous variables are involved with changes in GNP and GDP. 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, but the exact amount varies.
Further studies on the relationship of unemployment to production include a broader set of labor market variables to analyze the effects of the labor market on GNP and GDP. More detailed labor market 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.