Knotek (2007) examined whether the statistical relationship of real output growth with the unemployment rate, as captured by Arthur Okun’s simple rules of thumb, has been stable over time in the US. The paper showed that the relationship has varied over the business cycle, and more generally across history.
Picture by the New York Public Library, Unsplash
What is Okun’s law?
‘Okun’s law’ refers to a set of statistical relationships that describe the inverse relationship between changes in the unemployment rate and real economic output. Formulated by Arthur Okun in the early 1960s, it originally came in the form of two main versions, which are presented in Figure 1 below.
Figure 1: Okun’s law originally had two main general forms
Sources: Knotek (2007), Bonsai Economics.
Out of the two, Knotek (2007) argued that the ‘gap’ version is generally harder to use. After all, it relies on estimates of how much the economy would produce under conditions of maximum sustainable employment (‘potential output’), which can vary depending on the methodology used to derive it. The ‘difference’ version, in contrast, simply associates the unemployment rate with contemporaneous real economic output growth.
How stable is Okun’s coefficient?
Focusing on the ‘difference’ version, Knotek (2007) made two interesting observations about the historical stability of Okun’s coefficient (β from Figure 1 above).
First, Okun’s coefficient has generally tended to rise in periods of economic expansion. This is illustrated in Figure 2 below, which uses a five-year rolling sample to estimate the coefficient over time. In all four occurrences when the sample didn’t include recession periods, Okun’s coefficient estimate rose significantly.
Figure 2: Okun’s coefficient (β) has generally tended to rise in economic expansions
Source: Knotek (2007)
Second, in more recent periods, while the contemporaneous relationship between unemployment and real output has weakened, the relationship of unemployment with lagged real output has strengthened (see Figure 3, below). This finding favours forms of the ‘difference’ version which also include lags for economic output growth.
Figure 3: Lag coefficients are more important for more recent data
Source: Knotek (2007)
Conclusion
The upshot is that Okun’s law, contrary to the connotations of the word “law”, is only a rule of thumb, and the exact statistical relationship can vary over time and according to broader economic conditions. As a result, if one were to forecast the unemployment rate via Okun’s law, it would probably be more appropriate to use a more general form that captures its changing nature.
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