Okun’s Law

What is Okun’s Law ?

 Okun’s law is named after Arthur Okun, an economist who published his research on the relationship between two major macroeconomic variables unemployment and production and it states that “for every 1% fall in unemployment in an economy, the Gross Domestic Product (GDP) will rise by 2% and Gross National Product (GNP) will rise by 3%”. This means that unemployment is inversely proportional to the GDP and GNP of a country.

This law is known for its simplicity and accuracy. However, a lot of doubts have been raised on this law as it does not hold fit in every state for every economy. To make it clear, in an economy that is industrialized and has strong labor marketsLabor MarketsThe labour market, also known as the job market, is a well-studied market that operates on the supply and demand dynamics of people looking for work (workers) and organizations/people providing work (employers).read more, the percentage change in GDP will have less effect on the unemployment rate.

Okun’s Law Formula

Okun’s law is given by the following formula:

Okun's Law Formula 1

Where:

  • 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

So, the output gap (the difference between Actual GDP and Potential GDP) divided by Potential GDP is equal to the negative Okun coefficient (negative represents the inverse relationship between unemployment and GDP) multiplied by the change in Unemployment.

If we go by the traditional Okun’s law, the Okun coefficient would be 2 in all cases. However, in today’s scenario, this coefficient will not always be 2 and may vary according to economic situations.

Okun’s-Law-Formula

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Examples of Okun’s Law Formula (with Excel Template)

You can download this Okun's Law Excel Template here – Okun's Law Excel Template

Example #1

Let us take a hypothetical example where we have the following components given below and we have to calculate Okun Coefficient using the same.

Solution

From the below information, we have to calculate the Okun Coefficient.

ParticularsAmount (%)
Actual GDP (y)8.00
Potential GDP (y*)5.30
Unemployment Rate of Current Year (u)8.50
Unemployment Rate of Previous Year (u*)10.00

To calculate Okun’s coefficient, we need to first calculate the output gap

Calculation of Output Gap is as follows,

Okun's Law Formula Example 1.1
  • = 8.00-5.30
  • Output Gap = 2.7

Calculation of Okun’s Coefficient can be done as follows:

Okun's Law Formula Example 1.2
  • β =-2.7/(5.30*(8.50-10.00))

Okun’s Coefficient will be –

Okun's Law Formula Example 1.3
  • β = 0.34
  • Okun Coefficient (β) = 0.34

Example #2

Next, let us take a practical industry example of the USA Economy and we have been provided with the following data from the Research Team. Now from the data provided below, we have to calculate the Okun Coefficient.

Solution

From the below information, we have to calculate the Okun Coefficient.

ParticularsAmount (%)
Actual GDP (y)2.1
Potential GDP (y*)3.21
Unemployment Rate of Current Year (u)3.8
Unemployment Rate of Previous Year (u*)3.2

To calculate Okun’s coefficient, we need to first calculate the output gap

Calculation of Output Gap is as follows,

Okun's Law Formula Example 2.1
  • =2.1-3.21
  • Output Gap = -1.1

Calculation of Okun’s Coefficient can be done as follows:

Okun's Law Formula Example 2.2
  • β = -(-1.1)/(3.21*(3.8-3.2))

Okun’s Coefficient will be –

Okun's Law Equation Example 2.3
  • β = 0.58

Okun Coefficient is 0.58

Example #3

Let us take a practical industry example of the UK Economy and we have been provided with the following data from the Research Team. From the data provided below, we have to calculate the Okun Coefficient.

Solution

From the below information, we have to calculate the Okun Coefficient

ParticularsAmount (%)
Actual GDP (y)5
Potential GDP (y*)2
Unemployment Rate of Current Year (u)1
Unemployment Rate of Previous Year (u*)2.2

To calculate Okun’s coefficient, we need to first calculate the output gap

Calculation of Output Gap is as follows,

Okun's Law Equation Example 3.1
  • =5-2
  • Output Gap = 3

Calculation of Okun’s Coefficient can be done as follows:

okun's law formula Example 3.2
  • β = -3/(2*(1-2.2))

Okun’s Coefficient will be –

Okun's Law Equation Example 3.3
  • β = 1.25
  • Okun Coefficient = 1.25

Relevance and Use

The circle of the economy starts with investment. When people invest in any business, the relevant industry gets boosted. Investment results in an increase in production levels which requires the labor force and again it results in growth in the employment rate. So, a decrease in the unemployment rate eventually enhances the GDP of the country. Various industries and sectors (goods and service sector) contribute to the GDP of the country.

The Okun’s formula runs on this logic. Arthur Okun’s Law says that for every 1% decrease in unemployment, GDP will increase by 2%. However, this theory doesn’t hold good for every economy in today’s scenario. The Okun’s law acts in the same manner i.e. when the rate of unemployment decreases, the GDP of the country increases and vice versa but the Okun Coefficient may vary from country to country depending on the varying economic situations.

Recommended Articles

This has been a guide to Okun’s Law and its definition. Here we discuss formula to calculate Okun’s coefficient along with practical examples. You can learn more from the following articles –

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