Posted by John Irons at December 07, 1999 02:34 PM

Okun's law lives!

The US economy is performing nicely. The Bureau of Economic Analysis recently announced that real GDP in the US grew at an annual rate of 5.5% during the third quarter of 1999. Over the past four years real GDP growth has averaged about 4% per year. In another piece of good news, the unemployment rate is near a 30 year low of 4.1%, down from 4.5% in 1998 and down from a decade-high of 7.5% back in 1992.

The most recent experience - along with some simple logic - suggest that there is some relation between high output growth and unemployment. This relation is usually called Okun's law.

Named after the economist Arthur Okun and first formulated in the 1960's, the "law" captures an empirical relation between the unemployment rate and the growth in real output.  The relation says that the change in unemployment is given, approximately, by

Change in Unemployment = - 0.5  *  (growth - 3%).

In other words, for every point that GDP growth is above 3%, the unemployment rate falls by 1/2 a percentage point. (For example a 4% rate of growth in GDP would lead to a reduction in unemployment from 4.5% to 4.0% over the course of a year).

While this "law" was formulated back in the 60's, it has held up rather well over time. Figure 1 shows how nicely this relation has held up over the period from 1959 to 1998.

For the past three years, unemployment has been falling by about 1/2 percentage point per year, while growth has been around 4% -- matching Okun's law rather well. In contrast to many macroeconomic relationships, which are famous for their instability, Okun's law has been remarkably stable over time.

This relation, should it continue to hold up, may be a bit of a worry to Alan Greenspan. As long as we are growing at such a fast rate - and so long as Okun's law holds, we will see unemployment falling. However, unemployment cannot fall forever, since, at the very least, it is bounded by zero. Either Okun's law will have to give, or the economy will have to slow down.

Whether this happens on its own or by the hand of Mr. Greenspan is still up in the air, although the recent interest rate hikes indicate that the latter scenario is likely.
 
 

Figure 1.

Side Note: Okun's law is more generally given by:

Change in unemployment = - a (growth - b).

Figure 2.

More Features
Comments? Post in the Forum.

Data Sources: Department of Labor, NIPA, BEA, and author's calculations. Figures created by the author.

Posted by John Irons at December 07, 1999 02:34 PM