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Knotek, Edward S., II. "How Useful Is Okun's Law?." Economic Review (Kansas City, MO). Federal Reserve Bank of Kansas City. 2007. HighBeam Research. 26 Apr. 2018 <https://www.highbeam.com>.
Knotek, Edward S., II. "How Useful Is Okun's Law?." Economic Review (Kansas City, MO). 2007. HighBeam Research. (April 26, 2018). https://www.highbeam.com/doc/1G1-175548986.html
Knotek, Edward S., II. "How Useful Is Okun's Law?." Economic Review (Kansas City, MO). Federal Reserve Bank of Kansas City. 2007. Retrieved April 26, 2018 from HighBeam Research: https://www.highbeam.com/doc/1G1-175548986.html
From the beginning of 2003 through the first quarter of 2006, real gross domestic product in the United States grew at an average annual rate of 3.4 percent. As expected, unemployment during the period fell. Over the course of the next year, average growth slowed to less than half its earlier rate--but unemployment continued to drift downward. This situation presented a puzzle for policymakers and economists, who expected the unemployment rate to increase as the economy slowed.
Typically, growth slowdowns coincide with rising unemployment. This negative correlation between GDP growth and unemployment has been named "Okun's law." Part of the enduring appeal of Okun's law is its simplicity, since it involves two important macroeconomic variables. Additionally, the relationship appears to enjoy empirical support. In reality, though, Okun's law is a statistical relationship rather than a structural feature of the economy. As with any statistical relationship, it may be subject to revisions in an ever-changing macro economy.
Knotek considers the usefulness of Okun's law for policymakers and economists. The evidence suggests that Okun's relationship between changes in the unemployment rate and output growth has varied considerably over time and over the business cycle. Nevertheless, Okun's relationship can still be useful as a forecasting tool--provided that one takes its instability into account.
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From the beginning of 2003 through the first quarter of 2006, real gross domestic product in the United States grew at an average annual rate of 3.4 percent. As expected, unemployment during the period fell. Over the course of the next year, average growth slowed to less than half its earlier rate--but unemployment continued to drift downward. This situation presented a puzzle for policymakers and economists, who expected the unemployment rate to increase as the economy slowed.
Typically, growth slowdowns coincide with rising unemployment. This negative correlation between GDP growth and unemployment has been named "Okun's law," after the economist Arthur Okun who first documented it in the early 1960s. Part of the enduring appeal of Okun's law is its simplicity, since it involves two important macroeconomic variables. Additionally, the relationship appears to enjoy empirical support. In reality, though, Okun's law is a statistical relationship rather than a structural feature of the economy. As with any statistical relationship, it may be subject to revisions in an ever-changing macro economy.
This article considers the usefulness of Okun's law for policymakers and economists. It focuses on two questions. First, is Okun's law a reliable, stable relationship? Second, is the law a useful forecasting tool?
The evidence suggests that Okun's relationship between changes in the unemployment rate and output growth has varied considerably over time and over the business cycle. Nevertheless, Okun's relationship can still be useful as a forecasting tool--provided that one takes its instability into account.
The first section of this article examines the relationships first proposed by Okun. It also reviews the different versions of these relationships, which collectively are called Okun's law. The second section shows how the relationship between changes in unemployment and output growth has varied over time. The third section suggests two explanations for this variation. The fourth section considers how several different versions of Okun's law perform as forecasting tools.
I. WHAT IS OKUN'S LAW?
In his 1962 article, Okun presented two empirical relationships connecting the rate of unemployment to real output, which have become associated with his name. (1) Both were simple equations that have been used as rules of thumb since that time. In addition, both have been expanded on by economists to include elements that Okun omitted in his analysis. This section begins by describing the relationships that are commonly known as Okun's law. Okun's original estimates are then compared with estimates using a longer history of data.
Alternative versions of Okun's law
Okun's two relationships arise from the observation that more labor is typically required to produce more goods and services within an economy. More labor can come through a variety of forms, such as having employees work longer hours or hiring more workers. To simplify the analysis, Okun assumed that the unemployment rate can serve as a useful summary of the amount of labor being used in the economy.
The difference version. Okun's first relationship captured how changes in the unemployment rate from one quarter to the next moved with quarterly growth in real output. It took the form:
Change in the unemployment rate = a + [b.sup.*] (Real output growth). This relationship can be called the difference version of Okun's law. It captures the contemporaneous correlation between output growth and movements in unemployment--that is, how output growth varies simultaneously with changes in the unemployment rate. The parameter b is often called "Okun's coefficient." One would expect Okun's coefficient to be negative, so that rapid output growth is associated with a falling unemployment rate, and slow or negative output growth is associated with a rising unemployment rate. The ratio "-a/b" gives the rate of output growth consistent with a stable unemployment rate, or how quickly the economy would typically need to grow to maintain a given level of unemployment.
Using quarterly data from the second quarter of 1948 through the fourth quarter of 1960, which would have been available when Okun was writing his original article, one can estimate the above equation and find the following:
Change in the unemployment rate = 0.30 - [0.07.sup.*] (Real output growth). This is an example of a regression estimated using "real-time" data, or the data that had been available to economists at a point in the past. Real-time data are useful because they do not reflect the many revisions that macroeconomic statistics typically undergo. (2)
According to this estimate, zero real output growth in a given quarter was associated with an increase in the unemployment rate of 0.3 percentage point in that quarter. The rate of output growth consistent with a stable unemployment rate was a little more than 4 percent. Output growth faster than this rate typically coincided with a falling unemployment rate; slower growth typically coincided with a rising unemployment rate. The value of Okun's coefficient implied that each percentage point of real output growth above 4 percent was associated with a fall in the unemployment rate of 0.07 percentage point.
The gap version. While Okun's first relationship relied on readily accessible macroeconomic statistics, his second relationship connected the level of unemployment to the gap between potential output and actual output. In potential output, Okun sought to identify how much the economy would produce "under conditions of full employment" (page 98). (3) In full employment, Okun considered what he believed to be an unemployment level low enough to produce as much as possible without generating too much inflationary pressure.
A high rate of unemployment, Okun reasoned, would typically be associated with idle resources. In such a circumstance, one would expect the actual rate of output to be below its potential. A very low rate of unemployment would be associated with the reverse scenario. Thus Okun's second relationship, or the gap version of Okun's law, took the form:
Unemployment rate = c + [d.sup.*] (Gap between potential output and actual output).
The variable c can be interpreted as the unemployment rate associated with full employment. The coefficient d would be positive to conform to the intuition above.
The problem with both potential output and full employment is that neither is a directly observable macroeconomic statistic. As such, they allow for considerable interpretation on the part of the researcher. For instance, at the time of his writing Okun assumed that full employment occurred when unemployment was 4 percent. Based on this assumption and the gap equation, Okun was able to construct a series for potential output. But changing the assumption of what level of unemployment constituted full employment would produce a different measure of potential output. (4)
Aside from this issue, Okun noted that the simplicity of these equations could potentially be problematic. This has led economists to propose a number of variations on Okun's original relationships. These relationships are also often called Okun's law even though they differ substantially from the earlier equations.
The dynamic version. One of Okun's observations suggested that both past and current output can impact the current level of unemployment (page 102). In the difference version of Okun's law, this implies that some relevant variables have been omitted from the right side of the equation. Partly based on this suggestion, many economists now use a dynamic version of Okun's law.
A common form for the dynamic version of Okun's law would have current real output growth, past real output growth, and past changes in the unemployment rate as variables on the right side of the equation. (5) These variables would then explain the current change in the unemployment rate on the left side. (6) This dynamic version of Okun's law bears some similarities to the original difference version of Okun's law. However, it is fundamentally distinct since it no longer only captures the contemporaneous correlation between changes in the unemployment rate and real output growth. The dynamic relationship is not as restrictive in terms of the timing of the connection between output growth and changes in unemployment. But the drawback is that this relationship does not have the same simple interpretation as the original difference version of Okun's law.
Production-function versions. Okun also noted another shortcoming in his proposed relationships: The unemployment rate is at best "a proxy variable for all the ways in which output is affected by idle resources" (page 99). …
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