What Is Okun’s Law in economics?
What Is Okun’s Law Formula?
Okun’s law states that a one percent increase in output will result in a two percent decrease in the unemployment rate. This widely used equation was originally put forth by Arthur M. Okun, an economist who worked at the Federal Reserve Bank of St Louis back in 1962.
The original work on this theory is still considered to be some of the best ever performed on economic growth and employment relationships.
The simplest way to explain the relationship between unemployment and output is through Okun’s Law, which states that for every 1% rise in the rate of unemployment, there will be a 2% fall in GDP. The reverse holds true as well: if you reduce your national unemployment by 1%, you can expect to see your gross domestic product (GDP) increase by up to 3%.
Okun’s law asserts that a one-point rise in the cyclical unemployment rate correlates with two percentage points in the negative growth of real GDP. Relationships vary depending on the state and the time duration under consideration.
Okun Law Formula Equation
Okun’s law is a measure of the relationship between unemployment and changes in real GDP. Okun law is used to estimate the loss in output due to a one-percentage-point rise in the unemployment rate.
The Okun law states a relationship between the GDP growth in a country and its unemployment rate. The formula for this is:
- y = Actual GDP
- y* = Potential GDP
- β = Okun Coefficient
- u = Unemployment rate of the current year
- u* = Unemployment rate of the previous year
- y-y* = Output Gap
Usefulness of Okun Law formula
By comparing actual data with theoretical forecasting, Okun’s law proves to be an invaluable tool for predicting patterns between unemployment and real GDP. However, the precision of the data technically demonstrated by Okun’s law compared to real-world numbers appears to be generally incorrect. This is due to the variances in the Okun coefficient.
Many, including the Reserve Bank of Australia, believe that knowledge has been shown to be permissible to a certain extent by Okun’s rule. Also, several studies have concluded that Okun’s law appears to have higher accuracy rates for short-term rather than long-term forecasts.
Forecasters also concluded that this is true due to unforeseen market dynamics that may impact the Okun coefficient.
As such, Okun’s legislation is usually suitable to forecasters as a medium for a short-term trend analysis between unemployment and actual GDP, rather than being used for long-term analysis and precise numerical calculations.
What are the Criticisms and Shortcomings of the Okun Law formula Equation?
- The law is criticized for being too simplistic and only accounting for the changes in unemployment.
- One of the Okun law formula’s major criticisms is that it does not consider all elements that affect GDP. Though current growth rates are important, they do not paint a complete picture of an economy’s health in the long run.
- Okun’s Law is a formula that helps to predict the effect of an economic policy on aggregate output. It has its limitations, especially when it comes to small open economies.