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Thursday, March 30, 2006

Okun's Law Then and Now

I was curious to see if the relationship between unemployment and output has changed in recent years, so I took a very quick look at the issue through the lens of Okun's law (and used a simple textbook version of Okun's law as well). Recall that Okun's law is the negative relationship between unemployment and GDP. One way to look at this is to graph the growth of real GDP against changes in the unemployment rate. The data are quarterly, the sample period is 1948:Q2-2005:Q4,  and the changes are expressed in annual rates:

The equation for the fitted line is (GDP Growth) = 3.40 - 1.78ΔUN, not too far from the equation in, say, Mankiw's textbook where (GDP Growth) = 3 - 2ΔUN is used as a rough approximation (e.g. see page 35 in his 5th edition as well as the graph that is very similar to the one above).

The next step is to break the sample into two pieces. I chose 1982 as the break point. You will either like that or you won't, but it's what I chose for a first cut. The individual sub-sample graphs are similar to the total sample:

Here are the fitted lines for the two sub-samples:

And finally, here are the two estimated equations for the sub-samples:

(GDP Growth) = 3.73 - 1.87ΔUN for 1958:Q2-2005:Q4

(GDP Growth) = 2.99 - 1.49ΔUN for 1983:Q1-2005:Q4

The last set of results is close to (GDP Growth) = 3 - 1.5ΔUN if you like round numbers.

So what does this mean? Here are two observations:

  • For the full sample, unemployment will be stable (ΔUN=0) when GDP growth is 3.4%. For the sub-samples, the figures are 3.73% for sample through 1982, and 2.99% for the sample after 1982. Thus, rate of output growth producing stable employment has fallen according to these estimates.
  • For every percentage point unemployment increases in the early sample (i.e. an additional 1% increase over the last period), GDP growth falls by 1.87%. But in the later sample it falls less, by 1.49%.

I need to think through this more, but the decreased sensitivity of GDP growth to unemployment changes seems to be consistent with technological change allowing firms to replace people with machines more flexibly than in the earlier time period, with technological change allowing work to be digitized and performed elsewhere so that domestic unemployment can rise without output falling, and through the outsourcing of intermediate stages of production.

    Posted by on Thursday, March 30, 2006 at 01:26 AM in Economics, Unemployment | Permalink  TrackBack (0)  Comments (14)


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