Okun’s Law

Updated on April 10, 2024
Article byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

Okun’s Law Meaning

Okun’s Law refers to the observation on how the unemployment rate and losses influence the economic growth of a nation. According to this law, 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%.

Okuns-Law

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Okun’s Law helps an economy to be aware of the pace of growth it should maintain to ensure it never lags behind its global counterparts in terms of economic growth. The nations try their best to keep the rate of unemployment and other losses under control so that no negative impact is seen on the GDP.

Key Takeaways

  • Okun’s law is named after Arthur Okun. He was an economist who published his research on the relationship between two critical macroeconomic variables: unemployment and production. 
  • It states that “for every 1% reduction in unemployment in an economy, the Gross Domestic Product (GDP) may increase by 2% and Gross National Product (GNP) boosts by 3%.” 
  • This law is familiar for its simplicity and accuracy. However, many doubts are raised as it is appropriate in some states for some economies. Furthermore, in an industrialized economy with strong labor markets, the percentage change in GDP less influences the unemployment rate.

Okun’s Law Explained

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. It means that unemployment is inversely proportional to the GDP and GNP.

This law is known for its simplicity and accuracy. However, many 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 industrialized economy with 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.

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Formula

The following formula gives Okun’s law:

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, this coefficient will not always be two in today’s scenario and may vary according to economic situations.

Okun’s-Law-Formula

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Examples

Let us consider the following examples to see how the calculation is done:

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 information below, 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 first calculate the output gap

The 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 US 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 information below, 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 first to 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 first to 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 country’s GDP. Various industries and sectors (goods and service sector) contribute to the country’s GDP.

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. 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.

Frequently Asked Questions (FAQs)

Is Okun’s law positive or negative?

Okun’s law has a negative connection between changes in production and unemployment. Also, it shows the negative relationship between the unemployment rate and the output gap. Usually, the Okun coefficient is always -0.5, but that is only sometimes today. Often, the Okun coefficient varies based on the nation’s economic condition.

What are the implications of Okun’s law?

Okun’s law states that a country’s Gross Domestic Product (GDP) must increase at about a 4% rate for a year to get a 1% decrease in unemployment.

What is a criticism of Okun’s law?

Recovery begins the period after a trough and ends the period that employment reaches the pre-recession stage. One of Okun’s law criticisms is that it destroys during recoveries, specifically in the past three recoveries, termed “jobless recoveries.”

What does Okun’s law show when the unemployment rate is above the natural rate?

Okun’s law shows how much a country’s Gross Domestic Product (GDP) may be off-track if the unemployment rate is above the natural rate. In particular, the law states that a government must increase the gross domestic product (GDP) by 2% to get a 1% decrease in the unemployment rate.

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

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