An Analysis of Okun's Law

Matthew L.

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An Analysis of Okun's Law

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Abstract

Introduction:

This essay is split into three sections. In section 1, Okun's law will be examined, by looking at both of its forms. In section 2, the Okun's law coefficient will be analysed with particular reference to the factors which can affect the coefficient. In section 3, Okun's law will be applied in the context of a monetary contraction.

Explain Okun's law:

What is Okun's law? Surprisingly, it is not even actually a law as such, but a "rule of thumb" which remained valid for so long that it became commonly called a law (Ho,2002:76). Okun's law is a relationship linking output and employment negatively, which was proposed by Arthur Okun in 1962 (Attfield and Silverstone,1998:625). Below is a graph showing a typical best-fit line for an Okun's law scatter plot, although the scatter plot points have not been included on this diagram. This is just a demonstration of the general relationship between the change in the unemployment rate and the change in output. As we can see from the graph, this is a negative relationship.

Introduction
Explain Okun's law
What influences the effect on unemployment of a given deviation of output growth from normal?
1. Labour market participation
2. Training costs
3. Some workers are needed regardless of output level
4. Employment protection legislation
5. Politics
What role does Okun's law play in determining the effect of a monetary contraction?
Conclusion

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[...] The Okun's law coefficient, which has been previously mentioned, is the mechanism which affects unemployment for a given deviation of output growth from normal. The Okun's law coefficient has been described as for the gap equation, and for the growth equation. As already mentioned, the value for both coefficients has been stated as 0.4 in the US, so it means that we can just treat them as the same thing. However, the question refers to “output growth”, so we shall use here, and analyse it in the context of the growth rate equation. [...]

[...] This involves using other models as well as Okun's law as Okun's law is a relation between inflation and unemployment, whereas we need to look at interest rates to see the effects of monetary policy. This is because changing the real interest rate is how governments perform monetary expansions or contractions (De Long and Olney,2006:347). De Long and Olney present a basic version of the Taylor rule (2006:347), which can combine with Okun's law, and the IS curve to help analyse monetary policies. [...]

[...] Okun's Law Coefficients across Countries and Time The diagram below is an adaptation of the earlier graph, showing the effect of these five discussed factors. The new 45º line on this diagram represents what the line of best fit on an Okun's law scatter plot would look like if the value were 1. The line is 45º because that represents a gradient of where increase in output leads to a increase in the unemployment rate” (Blanchard,2006:186). However, we have already explored why this is not true. [...]

[...] (2006) Real Time Representations of the Output Gap, Birkbeck, School of Economics, Mathematics & Statistics:. Grant, A.P. (2002) 'Time-Varying Estimates of the Natural Rate of Unemployment: A Revisitation of Okun's Law', The Quarterly Review of Economics and Finance, 42:95-113. Ho, W.S. (2002) Okun Coefficient of Macao: Estimations and Applications, AMCM Quarterly Bulletin edition 5 edn, Monetary Authority of Macau Prachowny, M.F.J. (1993) 'Okun's Law: Theoretical Foundations and Revised Estimates', The review of economics and statistics, 75:331-36. Schnabel, G. (2002) 'Output Trends and Okun's Law', Bank for International Settlements, (BIS working paper no. [...]

[...] This corresponds with Schnabel's definition for the second form of Okun's law based on changes. Gap equation of Okun's law We will start by looking at the first form of Okun's law, which is known as a equation” (Attfield and Silverstone,1998:625). The equation below is a modification of an equation by DeLong and Olney (2006:341). It has been modified into a general form by replacing DeLong and Olney's values with algebraic variables: u = unemployment rate = natural rate of employment Y = real GDP = potential output = Okun's law coefficient, must be greater than 0 (represented by β by Attfield and Silverstone, (1998:625) but this would have confused matters when the growth rate equation is introduced later) This equation clearly shows the inverse relationship of output to employment through the negative sign in front of the Okun's law coefficient. [...]

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