What Is Okun's Law?

What Is Okun's Law?

Let me explain Okun's Law to you directly: it's an empirically observed negative correlation between GDP growth and unemployment. This means when unemployment goes up by 1%, GDP tends to drop by about 2%, showing how these economic elements are tied together. Even with some debates and variations, I find it a solid framework for grasping economic conditions and shifts in the labor market.

Exploring the Mechanics of Okun's Law

Arthur Okun, a Yale professor and economist born in 1928 and who passed in 1980, delved into how unemployment relates to production. He earned his Ph.D. at Columbia and served on the Council of Economic Advisors under Presidents Kennedy and Johnson. As a Keynesian, he pushed for fiscal policy to manage inflation and boost employment. In the 1960s, he proposed that falling unemployment leads to higher national production.

The Federal Reserve Bank of St. Louis puts it this way: Okun's Law shows how much GDP is lost when unemployment exceeds its natural rate. The reasoning is simple—output depends on labor input; more employed people mean more output. Okun originally stated that a one percentage point unemployment rise comes with a three percentage point GDP drop from potential levels, and vice versa. Potential GDP is what you get with full resource employment.

Fast Fact

Despite the name, most economists see Okun's Law as closer to a rule of thumb.

How Accurate Are Okun's Law Forecasts?

Okun's Law is essentially a rule of thumb based on observations, not strict theory. It's an estimate because things like capacity utilization and work hours impact output, which is why changes aren't one-to-one. For instance, Okun figured a three percentage point GDP rise from long-run levels includes 0.5 points from labor force participation, 0.5 from hours per employee, one from productivity, leaving one for unemployment change.

The relationship varies by country; in places like France or Germany with less flexible labor markets, GNP changes affect unemployment less than in the U.S.

Evaluating the Validity of Okun's Law

Okun's Law has held up at times but not always. A 2007 Kansas City Fed review of quarterly data found it largely accurate, though with unstable periods where unemployment didn't match predictions. They concluded it's not tight but does show growth slowdowns often mean rising unemployment. They also noted varying negative correlations between employment and productivity changes.

In other cases, it performed better than expected, like during the Great Recession where revised data aligned with predictions. San Francisco Fed researchers say it's a simple correlation that holds surprisingly well, with relationships similar to past recessions.

Fast Fact

Okun's coefficient shows the expected unemployment change with a 1% GDP increase, varying by country.

Limitations and Challenges of Okun's Law

Economists accept the productivity-employment link in Okun's Law, but disagree on its exact size. Many variables can affect these rates, complicating forecasts. That's why some view it as limited for predictions, even if the core relationship stands. A Cleveland Fed commentary highlighted rolling instability, with changes often far off predictions, across various law versions—suggesting it's not a reliable rule with too many exceptions.

What Is the Okun’s Law Equation?

There are different versions, but a simple one is U = a + b x G, where U is the quarterly unemployment rate change, G is real GDP growth, and b is Okun's coefficient, the slope of that relationship.

How Useful Is Okun’s Law?

Most economists accept the employment-output tie, but data often deviates from models. A Kansas City Fed review found unstable long-term relationships, yet it can still guide policymakers if they account for instabilities.

Does Okun’s Law Still Work?

It's an observation of unemployment-productivity correlation. Despite mismatches, it generally holds, as a 2014 San Francisco Fed review confirms it endures over time despite cycles.

Is Okun’s Law Inaccurate?

It's more rule of thumb than law, with many periods of larger or smaller changes than predicted. Still, the underlying tie persists despite variations.

The Bottom Line

Okun's Law, from the 1960s, notes a 1% unemployment change typically means 2-3% GDP shift. It holds as a rule of thumb over time, but economic conditions, labor flexibility, and other factors cause variations across countries. So, while it provides insights, don't rely on it alone for predictions.