Okuns law

Okuns law
See also
Constant price GDP Effective exchange rate GDP deflator Foreign trade multiplier Nominal exchange rate Economic climate Total factor productivity Rybczynski theorem National income measures

Okun's law is an empirical economic relationship that states that for every 1% deviation in unemployment from its natural rate, a nation's real gross domestic product (GDP) will change by approximately 2%. It was initially proposed by Arthur Okun, the chair of the Council of Economic Advisers under President John F. Kennedy, in 1962. This law is used to estimate the growth rate of an economy, and is also used to measure the effectiveness of government-led economic policies.

The formula for Okun's law is:

$\Delta y=-2\Delta u$

Where Δ y is the percentage change in real GDP and Δ u is the percentage change in the unemployment rate.

In other words, a 1% increase in unemployment corresponds to a 2% decrease in GDP, while a 1% decrease in unemployment corresponds to a 2% increase in GDP. This law has been found to hold true across different countries and different time periods, but its accuracy may vary depending on the specific economic circumstances of the country.

Example of Okun's law

To illustrate Okun's law, imagine a country with an initial unemployment rate of 6% and a real GDP of $100 billion. If the unemployment rate increases to 7%, then the real GDP would decrease by 2%, meaning the new real GDP would be $98 billion. If, on the other hand, the unemployment rate decreases to 5%, then the real GDP would increase by 2%, meaning the new real GDP would be $102 billion.

Overall, Okun's law is a useful tool for estimating the growth rate of an economy and measuring the effectiveness of government-led economic policies. It is important to note, however, that the accuracy of the law is dependent on the specific economic circumstances of the country, meaning it should not be used as a one-size-fits-all measure.

Formula of Okuns law

Okun's law can be expressed as a mathematical formula, which states that for every 1% deviation in unemployment from its natural rate, a nation's real gross domestic product (GDP) will change by approximately 2%. The formula is expressed as:

$\Delta y=-2\Delta u$

Where Δ y is the percentage change in real GDP and Δ u is the percentage change in the unemployment rate. This formula can be used to calculate the impact of changes in unemployment rates on the GDP of a country. For example, if the natural rate of unemployment is 6%, then an increase in unemployment of 1% would result in a decrease of 2% in the real GDP of the country.

When to use Okun's law

Okun's law is most often used when analyzing the impacts of macroeconomic policies on output and employment. For example, if a government implements a new policy to reduce unemployment, Okun's law can be used to estimate the potential increase in GDP that could result from the policy. It can also be used to estimate the effects of an economic downturn, such as a recession, on output and employment.

In addition to being used to evaluate the effects of macroeconomic policies, Okun's law is also used to assess the effectiveness of government-led economic stimulus programs. By comparing the estimated effects of the stimulus program to the actual changes in GDP and unemployment, policymakers can determine if the program was effective in achieving its intended objectives.

Advantages of Okun's law

• Okun's law provides a useful tool for economists to estimate the growth rate of an economy.
• It is a simple and easy-to-understand relationship that can be used to measure the effectiveness of government-led economic policies.
• It can be used to compare the economic performance of different countries over different time periods.

Disadvantages of Okun's law

• Okun's law does not take into account other economic factors, such as changes in international trade, that may affect GDP.
• It is an empirical relationship, which means it does not take into account the underlying theoretical relationships between unemployment and GDP.
• It can be inaccurate in certain economic circumstances, such as when the unemployment rate is very high or when the economy is facing a recession.

In conclusion, Okun's law is an empirical economic relationship that states that for every 1% deviation in unemployment from its natural rate, a nation's real GDP will change by approximately 2%. It is a useful tool for economists to estimate the growth rate of an economy, but its accuracy may vary depending on the specific economic circumstances of the country. It also has some disadvantages, such as not taking into account other economic factors and it being an empirical relationship.

Limitations of Okun's law

Despite its widespread use, there are some potential limitations to Okun's law.

• Firstly, the law assumes that the unemployment rate is a reliable indicator of economic activity. This is not always the case, as the unemployment rate can be affected by factors such as population growth, labor force participation, and technological advances.
• Secondly, the law relies on assumptions about how quickly the economy responds to changes in unemployment. This can vary significantly between countries and over time.
• Finally, the law does not take into account other factors that can affect the economy, such as government spending, taxes, and monetary policy.

Other approaches related to Okun's law

There are a few approaches related to Okuns law that are used to estimate the growth rate of an economy. These approaches include:

• Taylor Rule - this approach uses a formula to estimate the growth rate of an economy based on a country's inflation rate and the output gap.
• Phillips Curve - this approach is based on the inverse relationship between unemployment and inflation. It states that when unemployment is low, inflation tends to be high, and when unemployment is high, inflation tends to be low.
• Output Gap - this approach measures the difference between the actual real GDP and the potential real GDP. It is used to measure the potential for economic growth.

These approaches are used to measure the effectiveness of government-led economic policies and to estimate the growth rate of an economy. They all rely on Okun's law to some degree, as it is the basis for understanding the relationship between unemployment and GDP growth.

Overall, Okun's law is an empirical economic relationship that has been found to hold true across different countries and different time periods. It is used to measure the effectiveness of government-led economic policies and to estimate the growth rate of an economy, and is the basis for understanding the relationship between unemployment and GDP growth.

Suggested literature

• Cuaresma, J. C. (2003). Okun's law revisited. Oxford Bulletin of Economics and Statistics, 65(4), 439-451.