Learn the Definition What Is Okun's Law in Economics

It's the Relationship Between Output and Unemployment.

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In economics, Okun's Law describes the relationship between production output and employment. In order for manufacturers to produce more goods, they must hire more people. The inverse is also true. Less demand for goods leads to a decrease in production, in turn prompting layoffs. But in normal economic times, employment rises and falls in direct proportion to the rate of production at a set amount.

Who was Arthur Okun?

Okun's Law is named for the man who first described it, Arthur Okun (Nov. 28, 1928—March 23, 1980). Born in New Jersey, Okun studied economics at Columbia University, where he received his Ph.D. While teaching at Yale University, Okun was appointed to President John Kennedy's Council of Economic Advisors, a position he would also hold under Lyndon Johnson.

An advocate of Keynesian economic policies, Okun was a firm believer in using fiscal policy to control inflation and stimulate employment. His studies of long-term unemployment rates led to the publication in 1962 of what became known as Okun's Law.

Okun joined the Brookings Institution in 1969 and continued to research and write about economic theory until his death in 1980. He also is credited with defining a recession as two consecutive quarters of negative economic growth.

Output and Employment

In part, economists care about a nation's output (or, more specifically, its Gross Domestic Product) because output is related to employment, and one important measure of a nation's well-being is whether those people who want to work can actually get jobs. Therefore, it's important to understand the relationship between output and the unemployment rate.

When an economy is at its "normal" or long-run level of production (i.e. potential GDP), there is an associated unemployment rate known as the "natural" rate of unemployment. This unemployment consists of frictional and structural unemployment but doesn't have any cyclical unemployment associated with business cycles. Therefore, it makes sense to think about how unemployment deviates from this natural rate when production goes above or below its normal level.

Okun originally stated that the economy experienced a 1 percentage point increase in unemployment for every 3 percentage point decrease GDP from its long-run level. Similarly, a 3 percentage point increase in GDP from its long-run level is associated with a 1 percentage point decrease in unemployment.

In order to understand why the relationship between changes in output and changes in unemployment is not one-to-one, it's important to keep in mind that changes in output are also associated with changes in the labor force participation rate, changes in the number of hours worked per person, and changes in labor productivity.

Okun estimated, for example, that a 3 percentage point increase in GDP from its long-run level corresponded to a 0.5 percentage point increase in the labor force participation rate, a 0.5 percentage point increase in the hours worked per employee, and a 1 percentage point increase in labor productivity (i.e. output per worker per hour), leaving the remaining 1 percentage point to be the change in the unemployment rate.

Contemporary Economics

Since Okun's time, the relationship between changes in output and changes in unemployment has been estimated to be about 2 to 1 rather than the 3 to 1 that Okun originally proposed. (This ratio is also sensitive to both geography and time period.)

In addition, economists have noted that the relationship between changes in output and changes in unemployment is not perfect, and Okun's Law should generally be taken as a rule of thumb as opposed to as an absolute governing principle since it is mainly a result found in the data rather than a conclusion derived from a theoretical prediction.

Sources:

Encyclopaedia Brittanica staff. "Arthur M. Okun: American Economist." Brittanica.com, 8 September 2014.

Fuhrmann, Ryan C. "Okun's Law: Economic Growth And Unemployment." Investopedia.com, 12 February 2018.

Wen, Yi, and Chen, Mingyu. "Okun’s Law: A Meaningful Guide for Monetary Policy?" Federal Reserve Bank of St. Louis, 8 June 2012.