Okun’s Coefficient

Okun's coefficient is the relationship between changes in the unemployment rate and changes in output, named after the economist Arthur Okun. The coefficient measures the percentage change in output associated with a one-percentage-point change in the unemployment rate.

The Relationship

Okun's law states that a one-percentage-point increase in the unemployment rate is associated with a fall in output of about two to three percent, relative to potential output. The relationship is not a precise law but an empirical regularity, and the coefficient varies across countries and over time.

The relationship reflects the response of employment to output and the response of productivity to changes in output. When output falls, firms reduce employment, but they may also reduce hours and productivity, so that the change in unemployment is smaller than the change in output would suggest.

The Coefficient

The coefficient depends on the structure of the economy and on the institutions of the labour market. It is larger in economies where employment responds strongly to output, and smaller where the response is weaker.

The coefficient also depends on the time horizon. In the short run, the relationship between output and unemployment is weaker, since firms may hoard labour during temporary downturns. In the longer run, the relationship is stronger, as firms adjust their employment.

The estimates of the coefficient vary, with typical values between two and three for the United States and different values for other countries. The variation reflects the differences in the structure and in the institutions of the economies.

Uses

Okun's law is used to forecast the change in unemployment associated with a given change in output. It is used to assess the output gap from the observed unemployment rate, and to assess the unemployment rate consistent with potential output.

The relationship is also used in the analysis of policy, since it informs the assessment of the effects of a change in demand on employment. The assessment must take account of the uncertainty in the coefficient and of the variation across countries and over time.

Limitations

Okun's law is an empirical regularity, not a structural relationship, and it is subject to change. The relationship can break down during periods of structural change, when the response of employment to output changes.

The measurement of the variables is also subject to error. The measurement of output is subject to revision, and the measurement of unemployment depends on the definition of the labour force.

The use of the relationship for policy must therefore be cautious, and it must take account of the uncertainty and of the possibility that the relationship has changed.

The Original Statement

Okun's law was formulated by Arthur Okun in the early 1960s, in the context of the analysis of the relationship between output and unemployment in the United States. Okun observed that the relationship was stable enough to be used for forecasting and for policy.

The original statement held that a one-percentage-point reduction in the unemployment rate was associated with a three-percent increase in output, relative to potential. The precise coefficient has been revised and refined in subsequent work.

The law has been interpreted as a rule of thumb rather than a structural relationship. Its usefulness derives from the empirical regularity, and its interpretation requires attention to the conditions under which it was estimated.

The Sources of the Relationship

The relationship between output and unemployment reflects several mechanisms. The most direct is the change in employment, since a fall in output leads firms to reduce the number of workers.

The relationship also reflects the change in hours and in the participation of the labour force. Firms may reduce hours before reducing the number of workers, and some workers may leave the labour force when jobs are scarce.

The relationship also reflects the change in productivity. During downturns, firms may hoard labour, and the measured productivity may fall, which affects the relationship between output and unemployment.

The Coefficients Across Countries

The coefficients of Okun's law vary across countries, reflecting the differences in the structure of the economies and in the institutions of the labour market.

The coefficients tend to be larger in countries with more flexible labour markets, where employment responds strongly to output, and smaller in countries with more rigid markets. The coefficients also depend on the composition of employment and on the importance of the sectors that are more sensitive to the cycle.

The variation means that the relationship must be estimated for each country, and that the estimates must be updated as the structure of the economy changes. The use of the relationship for policy must take account of the uncertainty and of the variation.

Summary

Okun's law is the empirical relationship between changes in output and changes in unemployment. The coefficient varies across countries and over time, and its use for forecasting and for policy requires attention to its limitations and to the uncertainty in the estimates.

See also

• Economic Indicators
• Output Gap
• Labour Economics