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Essay on Okun's Law
Economist Arthur Okun observed a statistical regularity in the relationship between the change in the employment rate in an economy and the degree to which current real output (GDP) growth exceeded potential real output growth, usually assumed to be 3 percent per year. In an economic boom, GDP might grow at 6 percent per year, and the change in the employment rate was observed to be roughly one-third of the growth gap—one-third of 3 percent, or 1 percentage point. Okun's law thus gives a rough estimate of the change in the employment rate through economic growth cycles.
"Okun's law" describes an enduring empirical observation first made by Arthur Okun, relating departures from the natural rate of unemployment to changes in real output. This paper employs a recent development in trend-cycle decomposition of economic time series to measure the Okun coefficient using U.S. national and regional data.
Arthur Okun observed that "in the postwar period, on the average, each extra percentage point in the unemployment rate above four percent [that is, his estimate of what we would now refer to as the natural rate of unemployment] has been associated with about a three percent decrement in real GNP." Because Okun's empirical finding held up well during the ensuing decade, the 3:1 trade-off between real gross national product (GNP) growth and the unemployment rate became known as Okun's law. Since that time, a number of papers have established theoretical foundations for Okun's law and tested the stability of the 3:1 tradeoff. In general, Okun's law has withstood most challenges, although current estimates of the trade-off fall into a range closer to 2:1 than 3:1 and vary according t o the methods and specifications used. Variations notwithstanding, the stability of Okun's law contrasts favorably with the Phillips curve, its counterpart in the unemployment-inflation space.
Writing almost two decades later, however, and shortly before his death, Okun [1981, p. 228] himself doubted his law's stability: "During the late seventies, the three-to-one ratio [of real GNP to the unemployment rate] no longer approximated reality... .If employers encounter an unusually deep recession and expect the subsequent period of slack to be especially long lasting, they are likely to cut back employment more nearly in proportion to the decline in output..........
