What is Okun's Law?
Okun's law refers to the relationship between increases in unemployment and decreases in a country's gross domestic product (GDP). It states that for every 1% increase in unemployment above a "natural" level, that GDP will decrease by anywhere from 2% to 4% from its potential. This law is named after Arthur Okun, the economist who, in 1962, was the first to make detailed observations about this relationship. So-called "natural unemployment" refers to the fact that there will always be at least a certain amount of unemployment in a free market economy, because of voluntary changes in employment and other reasons not related to economic hardship.
Many economists have observed that Okun's law is really not a law at all, but more of a tendency that can vary based on a number of factors. Although it can be expressed mathematically, and holds up under real-world scrutiny, it is an imperfect theory. This is not as a result of any error on the part of Okun the economist, but rather because of unpredictability. For example, the exact amount of unemployment that constitutes "natural" unemployment is not known, nor can it be.
Another issue is that the effect of a given increase in unemployment could be magnified or diminished based on variables like productivity and general sentiment regarding the economy. These variables are, at best, hard to measure. The definition of unemployment — not having a job but still seeking one — also colors the data slightly, because it does not take into account those who stop looking for new work after a certain amount of time.
Despite these imperfections, Okun's law does describe a measurable economic trend in a way that helps economists and students of economics visualize a certain sequence of causes and effects. The observed relationship between more unemployment and lower GDP becomes intuitive, since people who are out of work not only stop producing, but also usually cut back significantly on spending. Also, lackluster economic data, such as high unemployment and low consumer spending, may discourage investment by businesses.
These two realities, when put together, make it easier to see that unemployment has a multiplier effect that is not limited to a one-for-one type of tradeoff. This is what the law accomplishes: namely, the description of this type of relationship as something to be expected. It also implies that unemployment is not the only thing that can affect GDP levels. If both productivity and the number of people in the labor force increase, for example, then GDP will increase even though unemployment statistics may have remained constant.
Can anyone tell me the link between Okun’s Law, The Phillips Curve and the simple aggregate demand/supply diagram?
@Catapult, it also is important to note that the Okun's Law idea does allow for a difference between, say, an increase in jobs and an increase in productivity; both can and do increase the income and general growth and prosperity of a nation. The problem, of course, is that when such people as poltiicians or business tycoons discuss growth, they often ignore that part of it; they talk about "jobs" rather than the work those jobs accomplish.
One reason for this difference could be that jobs are simply more interesting to people uninvolved in business; while you can count jobs, you can't "count" productivity. There are not as many facts and figures, and those statistics are what lure voters and keep them interested.
@sherlock87, while it is crtainly not foolproof at all, many people pay attention to Okun's law because it at least provides some way to watch and predict things like employment, income, and the general economic health of a nation.
Like any sort of business formula, Okun's law is not foolproof. However, it makes me realize this connection like I had not before. it also explains why people pay so much attention to "job growth", although that in itself will not necessarily improve the unemployment rate or raise GDP either.
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