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Economic News, Data and Analysis

Growth and Unemployment – Okun’s Law

Okun’s law lives!

The US economy is performing nicely. The Bureau of Economic Analysis
that real GDP in the US grew at an annual rate of 5.5% during the third quarter
of 1999. Over the past four years real GDP growth has averaged about 4%
per year. In another piece of good news, the unemployment
is near a 30 year low of 4.1%, down from 4.5% in 1998 and down
from a decade-high of 7.5% back in 1992.

The most recent experience – along with some simple logic – suggest
that there is some relation between high output growth and unemployment.
This relation is usually called Okun’s law.

Named after the economist Arthur
and first formulated in the 1960’s, the “law” captures an empirical
relation between the unemployment rate and the growth in real output. 
The relation says that the change in unemployment is given, approximately,

Change in Unemployment = – 0.5  *  (growth – 3%).

In other words, for every point that GDP growth is above 3%, the unemployment
rate falls by 1/2 a percentage point. (For example a 4% rate of growth
in GDP would lead to a reduction in unemployment from 4.5% to 4.0% over
the course of a year).

While this “law” was formulated back in the 60’s, it has held up rather
well over time. Figure 1 shows how nicely this
relation has held up over the period from 1959 to 1998.

For the past three years, unemployment has been falling by about 1/2
percentage point per year, while growth has been around 4% — matching
Okun’s law rather well. In contrast to many macroeconomic relationships,
which are famous for their instability, Okun’s law has been remarkably
stable over time.

This relation, should it continue to hold up, may be a bit of a worry
to Alan Greenspan. As long as we are growing at such a fast rate – and
so long as Okun’s law holds, we will see unemployment falling. However,
unemployment cannot fall forever, since, at the very least, it is bounded
by zero. Either Okun’s law will have to give, or the economy will have
to slow down.

Whether this happens on its own or by the hand of Mr. Greenspan is still
up in the air, although the recent interest rate hikes indicate that the
latter scenario is likely.



Figure 1.

Side Note: Okun’s law is more generally given by:

Change in unemployment = – a (growth – b).

Figure 2. shows the more general relation and suggests that rather
than have a=0.5, we should have a=0.35. Either way, the relation
holds up nicely over time.


Figure 2.

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Comments? Post in the Forum.

Data Sources: Department
of Labor
and author’s calculations. Figures created by the author.

Filed under: Data, Economy, Recession



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