Unemployment and Okun’s Law
The business cycle is apparent not only in data from the national income
accounts but also in data that describe conditions in the labor market. Figure
9-3 shows the unemployment rate from 1970 to early 2009, again with the
shaded areas representing periods of recession. You can see that unemployment
rises in each recession. Other labor-market measures tell a similar story. For
example, job vacancies, as measured by the number of help-wanted ads in newspapers, decline during recessions. Put simply, during an economic downturn,
jobs are harder to find.
What relationship should we expect to find between unemployment and real
GDP? Because employed workers help to produce goods and services and unemployed
workers do not, increases in the unemployment rate should be associated
with decreases in real GDP. This negative relationship between unemployment and
GDP is called Okun’s law, after Arthur Okun, the economist who first studied it.2
Figure 9-4 uses annual data for the United States to illustrate Okun’s law. In
this scatterplot, each point represents the data for one year. The horizontal axis
represents the change in the unemployment rate from the previous year, and the
vertical axis represents the percentage change in GDP. This figure shows clearly
that year-to-year changes in the unemployment rate are closely associated with
year-to-year changes in real GDP.
We can be more precise about the magnitude of the Okun’s law relationship.
The line drawn through the scatter of points tells us that
Percentage Change in Real GDP
= 3% − 2 × Change in the Unemployment Rate. If the unemployment rate remains the same, real GDP grows by about 3 percent;
this normal growth in the production of goods and services is due to growth in
the labor force, capital accumulation, and technological progress. In addition, for
every percentage point the unemployment rate rises, real GDP growth typically
falls by 2 percent. Hence, if the unemployment rate rises from 5 to 7 percent,
then real GDP growth would be
Percentage Change in Real GDP = 3% − 2 × (7% − 5%)
= −1%.
In this case, Okun’s law says that GDP would fall by 1 percent, indicating that
the economy is in a recession.
Okun’s law is a reminder that the forces that govern the short-run business
cycle are very different from those that shape long-run economic growth. As we
saw in Chapters 7 and 8, long-run growth in GDP is determined primarily by
technological progress. The long-run trend leading to higher standards of living
from generation to generation is not associated with any long-run trend in the
rate of unemployment. By contrast, short-run movements in GDP are highly correlated with the utilization of the economy’s labor force. The declines in the
production of goods and services that occur during recessions are always associated
with increases in joblessness.