What is Okun’s Law ?

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.

Okun’s Law Formula

The following formula gives Okun’s law:

Where:

  • y = Actual GDPy* = Potential GDPβ = Okun Coefficientu = Unemployment rate of the current yearu* = Unemployment rate of the previous yeary-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.

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Examples of Okun’s Law Formula (with 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.

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

Calculation of Output Gap is as follows,

  • = 8.00-5.30Output Gap = 2.7

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

  • β =-2.7/(5.30*(8.50-10.00))

Okun’s Coefficient will be –

  • β = 0.34Okun 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.

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

  • =2.1-3.21Output Gap = -1.1

  • β = -(-1.1)/(3.21*(3.8-3.2))

  • 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.

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

  • =5-2Output Gap = 3

  • β = -3/(2*(1-2.2))

  • β = 1.25Okun 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.

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

  • Command EconomyCommand EconomyCommand economy is a system where the government decides goods production, process, quantity, and price in a country. In this system, the government even manages income and investments. Communist nations like the former Soviet Union, Cuba, North Korea work according to this system.read moreGDP vs GNPGDP Vs GNPGross domestic product (GDP) is a measure of national production for the entire year, whereas gross national product (GNP) is a measure of annual output or production by citizens of a country, whether in their home country or abroad, and thus the country’s border is not taken into account in GNP calculation.read moreFormula of GDP DeflatorCalculate GDP using Expenditure Approach