OKUNS law description, Lecture notes of Macroeconomics

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EC 216

Intermediate Macroeconomics

& Introduction to Data Analysis

Lecture: Okun’s Law

Teaching Associate Idil Edes Gallop

idil.edes-gallop@strath.ac.uk

University of Strathclyde

OVERVIEW

We characterize the economy by three relations:

Okun’s Law : a relation between output growth and the change in unemployment Phillips Curve : a relation between unemployment, inflation, and expected inflation Aggregate Demand : a relation between output growth, money growth, and inflation.

OKUN’S LAW

Given productivity, output moved with employment:

ut − ut− 1 = −gyt

The change in the unemployment rate should be equal to the negative of the growth rate of output. For example : If output growth is 4% then the unemployment rate should decline by 4%.

Extending our analysis of employment and output

ut − ut− 1 = −β(gyt − gy)

OKUN’S LAW (^) ut − ut− 1 = −β(gyt − g y)

The actual relation between output growth and the change in the unemployment rate is known as Okun’s law

ut − ut− 1 = − 0. 4 (gyt − 3%)

Using 30 years of data, the line that best fits the data!

OKUN’S LAW

ut − ut− 1 = − 0. 4 (gyt − 3%)

Suppose the economy is growing at 4 % What would be the reduction in unemployment rate?

Why is it less than one-for-one?

1. Labor hoarding: firms prefer to keep workers rather than lay them off when output decreases.
2. When output increases, the employment pool increases, those who were out of the labor force participate. Thus, not all the newly available jobs go to unemployed.

OKUN’S LAW

ut − ut− 1 = −β(gyt − gy)

Output growth above (below) normal leads to a decrease (increase) in the unemployment rate.

This is Okun’s law:

gyt > gy ⇒ ut < ut− 1

gyt < gy ⇒ ut > ut− 1

OKUN’S LAW

The econometrics of Okun’s Law

Regression equation: Δ u t = α+β g t + εt

where

• Δ u t is the change in the unemployment rate at time t
• g t is the year on year growth rate in real GDP at time t
• α is the intercept value, and
• β is a coefficient determining how real GDP growth is predicted to be translated into a change in unemployment rate. We expect β to be negative.

OKUN’S LAW

Estimates for Germany

using data from 1970-

Predicted Δ u t = 0.57 - 0.21 g t ᡄ⡰^ = 0.

To work out the predicted percentage change in the unemployment rate for Germany in 2009, plug in the value of GDP growth for Germany in 2009 and solve the equation:

Predicted Δ u t in 2009 = 0.57 - 0.21 x (-5.1) = 1.

So Okun’s law predicts that the fall in GDP of 5.1% in 2009 should have been associated with an increase in the unemployment rate of 1.641%. In fact Germany managed to protect jobs…