Okun's law

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Graph of US quarterly data (not annualized) from 1947 through 2002 produces the equation: %Change GNP = .856 - 1.827*(Change Unemployment Rate). R^2 of .504. Differences from other results partly the result of using quarterly data.

In economics, Okun's law, named after economist Arthur Okun who proposed the relationship in 1962 (Prachowny), describes a relationship between the change in the rate of unemployment and the difference between actual and potential real GDP. In the United States during the period since 1965 or so, Okun's law can be stated as saying that for every one percentage point by which the actual unemployment rate exceeds the "natural" rate of unemployment, there is a 2 to 4 % "GDP Gap". That is, unemployment above the inflation-threshold unemployment rate corresponds to real gross domestic product below potential output.

Okun's law is more accurately called "Okun's rule of thumb" because, like Moore's law in semiconductors, it is a stylized fact rather than being clearly based on economic theory. The relationship varies depending on the country and time-period under consideration.

The relationship is represented by a ratio of 1 to 2.5. Thus, for every 1% excess of the natural unemployment rate, a 2.5% GDP gap is predicted.

The relationship has been tested by regressing change in the unemployment rate on GDP or GNP growth. The empirical result has generally about a 3 point increase in output for ever 1 point change in the unemployment rate (Prachowny).

One implication of Okun's law is that an increase in labor productivity together with an increase in the size of labor force can mean that real net output grows without net unemployment rates falling (the phenomenon of "jobless growth.")

References

Case, Karl E. & Fair, Ray C. (1999). Principles of Economics (5th ed.). Prentice-Hall. ISBN 0-13-961905-4.
Okun's Law: Theoretical Foundations and Revised Estimates
Prachowny, Martin F. J. The Review of Economics and Statistics, Vol. 75, No. 2. (May, 1993), pp. 331-336. [JSTOR (Subscription only)]

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