How useful is Okun's Law?

Edward S. Knotek asks an interesting question in the latest Kansas City Fed's Economic Review: How Useful is Okun's Law? (PDF)

From the beginning of 2003 through the first quarter of 2006, real gross domestic product in the United States grew at an average annual rate of 3.4 percent. As expected, unemployment during the period fell. Over the course of the next year, average growth slowed to less than half its earlier rate--but unemployment continued to drift downward. This situation presented a puzzle for policymakers and economists, who expected the unemployment rate to increase as the economy slowed.

Typically, growth slowdowns coincide with rising unemployment. This negative correlation between GDP growth and unemployment has been named “Okun’s law.” Part of the enduring appeal of Okun’s law is its simplicity, since it involves two important macroeconomic variables. Additionally, the relationship appears to enjoy empirical support. In reality, though, Okun’s law is a statistical relationship rather than a structural feature of the economy. As with any statistical relationship, it may be subject to revisions in an ever-changing macro economy.

Knotek considers the usefulness of Okun’s law for policymakers and economists. The evidence suggests that Okun’s relationship between changes in the unemployment rate and output growth has varied considerably over time and over the business cycle. Nevertheless, Okun’s relationship can still be useful as a forecasting tool--provided that one takes its instability into account.

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