Okun's Law
What is Okun's Law?
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.
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.
Okun's Law: a worked example
Write the relationship as percentage output gap equals negative 2 times the cyclical unemployment gap. Take a natural rate of 5 percent and actual unemployment of 8 percent. Cyclical unemployment is 8 minus 5, or 3 percentage points, so the output gap is negative 2 times 3, or negative 6 percent. With potential real GDP of $9,000 billion, actual output is 9,000 times 0.94, or $8,460 billion, and the economy is forgoing $540 billion of production. Run it backwards to check. If actual GDP is $8,730 billion against the same potential, the gap is negative 270 divided by 9,000, or negative 3 percent. Divide by 2 to recover cyclical unemployment of 1.5 points, so actual unemployment is 5 plus 1.5, or 6.5 percent.
The mistake students make with okun's law
The error that costs the most points is plugging the whole unemployment rate into the formula instead of the cyclical part. A student sees 5 percent unemployment, multiplies by 2, and reports a 10 percent output gap, when an economy sitting exactly at a 5 percent natural rate has no gap at all. Subtract the natural rate first. The second slip is running the coefficient the wrong way. Unemployment gaps multiply by 2 to give output gaps. Output gaps divide by 2 to give unemployment gaps.
Okun's Law questions
What is the formula for Okun's law?
Okun's law is usually written as the percentage output gap equals negative c times the difference between the actual and natural unemployment rates, with c commonly set near 2. Read left to right, every percentage point of unemployment above the natural rate corresponds to real GDP falling roughly 2 percent below potential. Some textbooks state it in changes instead, relating the change in unemployment to the growth rate of output, so check which version a question wants.
Why is the Okun coefficient about 2 instead of 1?
Output falls faster than the headcount of unemployed people because firms cut labor input in several ways at once. Overtime disappears, hours per worker shrink, and firms hold on to trained staff who are not fully occupied, so measured productivity per worker sags. On top of that, discouraged workers leave the labor force entirely and never enter the unemployment count, which hides part of the lost labor input. Stack those effects and a one-point unemployment rise costs well more than one percent of output.
Is Okun's law an actual law?
Okun's law is an empirical regularity, not a theoretical identity like MV equals PY or the expenditure equation for GDP. The coefficient is estimated from data and shifts across countries and across decades, since it depends on labor market flexibility, how easily firms can adjust hours, and how quickly discouraged workers leave the labor force. Treat the value near 2 as a serviceable rule of thumb for exam arithmetic while remembering that a real estimate carries error around it.
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