Okun’s Law, Coefficient of Okun’s Law and Measuring the Macroeconomy

Okun’s Law:

In the U.S. since World War II, the unemployment rate has been tightly coupled with the rate of increase of real GDP in a relationship known as Okun's Law (see Figure).

(Percentage Change in Real GDP) = (Percentage Growth in Potential Output) – 2.5 *(Percentage – Point Change in Unemployment Rate)

318_okuns law.jpg

Due to Okun's Law, if you know what’s happening to real GDP relative to possible output, you have a good thought of what’s happening to unemployment rate and vice versa. Box below explains the aspects of Okun's Law in detail.

Why the Okun's Law Coefficient is so Large?

Okun's Law posits not a one to one relation but a 2.5 to one relationship between real GDP progress and the joblessness rate. Which is, a 1% point fall in the joblessness rate is associated not with a 1 but 2.5% increase in the level of production.

Why is this Okun's Law coefficient so large? Why isn't it case that a 1% point fall in unemployment creates a 1% rise in output, or even less? One answer is that unemployment rate, as formally measured, doesn’t count discouraged workers. In a recession, the number of people at job falls, the number of people looking for job rises, and the number of people who aren’t looking for job since they doubt they could find employments but would be working if business situations were better, rises. Since the conventionally measured joblessness rate doesn’t include these discouraged workers, more than a 1% rise in real GDP is needed to decrease the joblessness rate by 1% point.

Moreover, when business returns to normal, firms' early response is not to employ more employees, but to ask on hand employees to work longer hours. So average hours of work for every week go up, and the unemployment rate falls by less than one would be expecting.

Finally, in a number of industries employing more workers raises production by more than a proportional quantity: product design and set-up need to be done only one time, no matter how much is manufactured. So businesses which have economies of scale don’t need two times as many workers to make twice as much output.

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