Oaken's Law. Okun's coefficient: definition, formula

2024 Author: Henry Conors | [email protected]. Last modified: 2024-02-12 02:55

Okun's law is often used to analyze the economic situation. The coefficient, which was derived by the scientist, characterizes the relationship between the unemployment rate and growth rates. It was discovered on the basis of empirical data in 1962 by the scientist after whom it was named. Statistics show that an increase in unemployment by 1% leads to a decrease in actual GDP from potential GDP by 2%. However, this ratio is not constant. It may vary by state and time period. The relationship between quarterly changes in the unemployment rate and real GDP is Okun's Law. The formula, it should be noted, is still criticized. Its usefulness for explaining market conditions is also questioned.

Oaken's Law

The coefficient and the law behind it appeared as a result of the processing of statistical data, that is, empirical observations. It was not based on the original theory, which was then tested in practice. Arthur Melvin Oaken saw the pattern while studying US statistics. It is approximate. It's connected withThe fact that the gross domestic product is influenced by many factors, and not just the unemployment rate. However, such a simplistic view of the relationship between macroeconomic indicators is sometimes also useful, as Oken's study shows. The coefficient derived by the scientist displays an inversely proportional relationship between the volume of production and the unemployment rate. Okun believed that the 2% increase in GDP was due to the following shifts:

• drop in cyclical unemployment by 1%;
• 0.5% increase in employment;
• an increase in the number of working hours for each worker by 0.5%;
• 1% increase in productivity.

Thus, by reducing Okun's cyclical unemployment rate by 0.1%, we can expect real GDP to increase by 0.2%. However, this ratio varies for different countries and time periods. The relationship has been tested in practice for both GDP and GNP. According to Martin Prachovny, a 3% decrease in output is associated with a 1% decrease in unemployment. However, he believes that this is only an indirect dependence. According to Prachovny, production volumes are influenced not by unemployment, but by other factors, such as capacity utilization and the number of hours worked. Therefore, they must be discarded. Prachovny calculated that a 1% decrease in unemployment leads to GDP growth of only 0.7%. Moreover, the dependence becomes weaker over time. In 2005, an analysis of recent statistics was conducted by Andrew Abel and Ben Bernanke. According to them, the increaseunemployment by 1% leads to a fall in output by 2%.

Reasons

But why does GDP growth exceed the percentage change in the unemployment rate? There are several explanations for this:

• Action of the multiplicative effect. The more people employed, the greater the demand for goods. Therefore, output can grow faster than employment.
• Imperfect statistics. Unemployed individuals may simply stop looking for work. If this happens, then they disappear from the "radar" of statistical agencies.
• Again, those actually employed may start working less. It is practically not shown in the statistics. However, this situation significantly affects production volumes. Therefore, with the same number of employees, we can actually get different indicators of the gross product.
• Decrease in labor productivity. This may be due not only to a deterioration in the organization, but also to an excessive number of employees.

Oaken's Law: Formula

Introduce the following conventions:

• Y is real output.
• Y’ is potential gross domestic product.
• u is real unemployment.
• u’ is the natural level of the previous indicator.
• c – Okun's coefficient.

Taking into account the above conventions, we can derive the following formula: (Y’ – Y)/Y’=с(u – u’).

In the US, since 1955, the last figure has usually been 2 or 3, like thisshown by the above empirical studies. However, this version of Okun's law is rarely used because potential unemployment and gross domestic product levels are difficult to estimate. There is another version of the formula.

How to calculate GDP growth

To calculate the GDP growth rate, we introduce the following symbols:

• Y is the actual issue volume.
• ∆u is the change in the actual unemployment rate compared to last year.
• C – Okun's coefficient.
• ∆Y is the change in actual output from last year.
• K is the average annual production growth at full employment.

Using these notations, we can derive the following formula: ∆Y/Y=k – c∆u.

For the modern period in US history, the coefficient C is 2, and K is 3%. Thus, the equation is derived: ∆Y/Y=0.03 - 2∆u.

Use

Knowing how to calculate Okun's ratio often helps with trending. However, often the resulting numbers are not very accurate. This is due to the variability of the coefficient for different countries and time periods. Therefore, the received predictions of GDP growth due to job creation should be taken into account with a certain degree of skepticism. Moreover, short-term trends are more accurate. This is due to the fact that any market changes can affect the coefficient.

In practice

Assume that the unemployment rate is 10% andthe actual gross domestic product is 7500 billion currency units.

We need to find the amount of GDP that could be achieved if the unemployment rate corresponded to the natural indicator (6%). This problem is easily solved using Okun's law. The coefficient shows that the excess of the actual unemployment rate over the natural one by 1% leads to a loss of 2% of GDP. So first we need to find the difference between 10% and 6%. Thus, the difference between the actual and natural unemployment rate is 4%. After that, it is easy to understand that GDP in our problem lags behind its potential value by 8%. Now let's take the actual gross domestic product as 100%. Further, we can conclude that 108% of real GDP is 75001.08=8100 billion monetary units. It must be understood that this example is only an example from an economics course. In reality, the situation may be completely different. Therefore, the use of Okun's law is only suitable for short-term forecasting, where there is no need for extremely accurate measurements.