Okun's Law vs Phillips Curve
Okun's Law and Phillips Curve are related concepts in AP Economics that students often mix up. Okun's law is the observed relationship that each extra percentage point of cyclical unemployment is associated with roughly a 2% fall in real GDP below potential. The Phillips curve shows the short-run inverse relationship between the inflation rate and the unemployment rate. Here is how they compare side by side.
It links the labor market to output: when unemployment rises above its natural rate, GDP falls below potential by a multiple of that gap. The exact ratio varies, but it shows the large output cost of high unemployment.
In the short run, lower unemployment tends to come with higher inflation, giving policymakers a trade-off. The long-run Phillips curve is vertical at the natural rate of unemployment, so there is no permanent trade-off: pushing unemployment below the natural rate only raises inflation. It is the inflation-unemployment counterpart of the AD-AS model.
Okun's Law vs the Phillips Curve: One Translates, the Other Trades Off
| Okun's Law | Phillips Curve | |
|---|---|---|
| What it links | Cyclical unemployment to the real output gap | The unemployment rate to the inflation rate |
| Type of relationship | Real to real, an empirical regularity | Real to nominal, and it depends on expected inflation |
| What the relationship gives you | A number you can compute with, roughly two percent of output per point of cyclical unemployment | A direction and a position on a curve, with no coefficient you are asked to apply |
| Long run version | None, it describes deviations from potential rather than a tradeoff | Vertical at the natural rate, so the tradeoff disappears |
| What shifts it | Little, it is treated as a fixed conversion factor | Expected inflation and supply shocks shift the short run curve |
| Use in a free response question | Convert a stated output gap into an unemployment gap, or the reverse | Price the inflation cost of closing that output gap |
| Behavior in stagflation | Holds, though a permanent shock lowers potential so the gap has to be recomputed | Appears to break, since inflation and unemployment rise together |
Chain them and one output gap gives you an unemployment rate and an inflation direction
Start with a hypothetical economy where potential real GDP is 500 billion dollars and actual real GDP is 480 billion, a gap of 4 percent below potential. Okun's relationship does the first conversion. With the two to one ratio used in class, a 4 percent output shortfall corresponds to about 2 percentage points of cyclical unemployment, so if the natural rate is 5 percent the actual unemployment rate sits near 7 percent. The Phillips curve then prices that position. At 7 percent unemployment the economy sits low and to the right on the short run curve, where inflation runs below what people expected. Expansionary policy that closes the output gap walks the economy back up that same short run curve, and the inflation cost shows up there. Okun translated the gap into unemployment, the Phillips curve translated unemployment into inflation. Neither does the other's job, and free response questions often need both steps in sequence.
A supply shock is the case where Okun's inputs move, not just the Phillips curve
A negative supply shock raises inflation and unemployment together, which is the case people cite as the Phillips curve failing. Okun's relationship is the one worth watching instead, because what the shock does to it depends on whether potential output moved. Keep the earlier economy, potential 500 billion dollars and actual output 480 billion. If the shock is temporary and only short run aggregate supply shifted, potential is still 500, the gap is still 4 percent, and Okun converts that to about 2 points of cyclical unemployment on top of a 5 percent natural rate, so unemployment sits near 7 percent. Now suppose the shock is permanent and potential falls to 490 billion. Actual output is unchanged at 480, but the gap is now about 2 percent, so cyclical unemployment is only about 1 point. If the natural rate rose to 6 percent at the same time, measured unemployment is still near 7 percent. Same headline number, half as much of it cyclical, and only the cyclical half is what demand policy can remove. That recomputation against a new potential is the step a supply shock question is really testing, and the Phillips curve will not hand it to you, since it prices unemployment rather than measuring it.
Okun's relationship has no long run version, and that asymmetry decides which tool a question wants
The Phillips curve comes in two forms, a downward sloping short run curve and a vertical long run curve at the natural rate. Okun's relationship has only one form. Nothing about expectations shifts it, no vertical version of it exists, and no long run Okun's law was ever proposed, because the relationship was never a tradeoff a policymaker could try to exploit. It is a conversion between two ways of measuring the same slack. The practical consequence is that the two are not interchangeable in a long run question. Asked what happens after a sustained demand expansion, the required answer is the vertical long run Phillips curve and a return to the natural rate at higher inflation. Offering an output to unemployment ratio there scores nothing, because once the gap has closed there is no gap left to convert. Okun earns its marks earlier in the answer, at the point where a question hands you potential and actual output and expects an unemployment rate before any policy has acted.
Frequently asked questions
Why does the Phillips curve have a long run version when Okun's law does not?
The Phillips curve links a real variable, unemployment, to a nominal one, inflation, and that link depends on whether the inflation was expected. Once expectations catch up, only the natural rate survives, which is exactly what the vertical long run curve records. Okun's relationship links two real variables, the output gap and cyclical unemployment, so no expectational adjustment can undo it. A relationship between two real quantities has no nominal illusion to wear off.
Which relationship survives stagflation?
Okun's relationship survives, since output below potential and unemployment above the natural rate still travel together when a supply shock hits. The one caution is that a permanent shock lowers potential itself, so the gap has to be measured against the new potential before the conversion is run. The Phillips curve looks broken during stagflation only because the short run curve shifted rather than the economy moving along it.
How do you use both in a single free response question?
Okun's relationship converts a stated output gap into an unemployment gap, and the Phillips curve then places that unemployment rate on the short run curve to say what inflation is doing. A question that hands you potential and actual real GDP and then asks about inflation wants both steps. Do the conversion first, name the natural rate, then describe the position on the short run curve and the direction any policy response would move it.
Live Phillips Curve graph. Drag the curves, or open the full version.
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