OKUN’S LAW

The most distress sing consequence of recession is a rise in the unemployment rate, As output falls, firms need fewer labor inputs: so new workers arc not hired and current workers arc bid off. The impact can be dram of the recession of 1981-1982, about lout 01 10 American workers was unemployed, Conditions in Europe were equally depressed in the mid-1990s, when reached over 10 percent of the workforce.

It turns out that unemployment usually moves in tandem with output over the business cycle. The remarkable co-movement of output and unemployment, along with the numerical relationship, was first identified by Arthur Okun and is known as Okuns Law.

This means that if GOP begins at 100 percent of its potential and falls to 98 percent of potential, the unemployment rate rises by 1 percentage point, say, from 6 to i percent. Figure 31-5 shows how output and unemployment have moved together over time. We can illustrate Okun’s Law by examining output and unemployment trends in the 1990s. Ouring the last recession in 1991, the unemployment rate rose to 6.9 percent. At that point, actual GOP was estimated to be 2.5 percent below potential output. Then, over the next 9 years, grew 5.8 percent faster than potential output, so that in 1999 actual GOP was estimated to be 3.3 percent above potential output. According to Okun’s Law, the unemployment rate should have fallen by 2.9 per centage points (5.8/2) to 4.0 percent (6.9-2.9). In fact, the unemployment rate for 1999 was 4.2 percent- a remarkabiy accurate prediction.

This shows how Okurr’s Law can be used to relate changes in the unemployment rate to the growth in output. One important consequence of Okun’s Law is that actual GOP must grow as rapidly as potential GOP just to keep the unemployment rate from rising. In a sense, COP has to keep running just to.keep unemployment in the same place. Moreover, if you want to bring the unemployment rate down, actual GOP must be growing faster than potential GOP, Okuu’s Law provides the vital link between the output market and the labor market. It describes the association between’ short-run movements in real GOP and changes in unemployment.