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In 1992, Okun gave two empirical associations linking the unemployment rate to real output, through simple equations. This association obtained the name Okun’s law. This paper describes the associations that get described as Okun’s law. The two associations of Okun stem from the examination that additional labor becomes required to create more products and services in an economy.
Additional labor can emerge from various approaches, such as making employees work for more hours or employing more personnel. Okun supposes that the rate of unemployment can act as a valuable review of the quantity of labor that an economy uses (Cuaresma 439). The following is a discussion of Okun’s law versions.
The Difference: First Relationship
This first relationship demonstrates the way change in the rate of unemployment between quarters shifts with quarterly increase in real output. The version can be explained by the following equation.
Change in the rate of unemployment = a + b (Real output growth) (Prachowny 333).
This association can be referred as the difference version of Okun’s law. The association demonstrates the simultaneous relationship between changes in unemployment and the expansion of output. This is how expansion in output diverges concurrently with movements in the rate of unemployment. The factor b gets referred as Okun’s coefficient. We would anticipate a negative Okun’s coefficient, in order to associate swift output growth with a declining rate of unemployment. Conversely, a negative or slow output increase can be related to an increasing unemployment rate.
Knotek (75) used quarterly information from the 2nd quarter of 1948 to the 4th quarter of 1960, to estimate the equation above, and he established several facts, as discussed below.
Unemployment rate Change = 0.30 – 0.07 (Real output growth) (Knotek 75).
Going by this approximation, a real output growth of zero in a certain quarter became related to a rise of 0.3 percentage, in the unemployment rate, during that quarter. The increase in rate of output, invariable with a stable rate of unemployment, was slightly above 4%.
The figure of Okun’s coefficient indicated that every percentage point above 4%, of real output growth, became related with a decrease in the rate of unemployment of 0.07 % point (Knotek 75).
The gap: Second Relationship
Whereas difference Version depended on readily available macroeconomic statistics, Okun’s second relationship linked the unemployment height to the gap amid actual output and potential output. Okun tried to discover the amount that the economy would generate, in potential output, under circumstances of full employment. Okun thought of what he deemed, an adequate, low unemployment level, to create as much as feasible without creating lots of inflationary force, in full employment.
Also, Okun thought that a high unemployment rate would, characteristically, be linked with redundant resources (Cuaresma 439). We would anticipate the actual rate of output to be less than its potential, in such a situation. An extremely low rate of unemployment became linked to the opposite scenario. Therefore, the gap version of Okun’s law takes the form illustrated below.
Rate of Unemployment = c + d (Cuaresma 445; Knotek 75).
The c, which is a variable, may be construed as the unemployment rate related to full employment. So as, to follow the above intuition, coefficient d should be positive.
Full employment and potential output cause setback since both are not directly visible macroeconomic statistic. Particularly, they make a room for substantial elucidation on the side of the researcher.
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Okun formulated the production-function versions after realizing another fault in his suggested relationships. He realized that the rate of unemployment was an alternative variable for the entire approaches in which output got influenced by redundant resources. This consideration founded production-function versions of Okun’s law, which usually merges a hypothetical production function to create output, using the gap-based version of the law.
At some point, Okun made observations that both current and previous output could affect the present height of unemployment. Within the difference version of Okun’s law, this means that several related variables must have faced elimination from the right part of the equation.
At present, several economists employ a dynamic version of Okun’s law, basing on this submission. Variables on the right part of the equation, in a regular structure for the dynamic version of Okun’s law, should include past real output growth, current real output growth and past changes in the rate of unemployment (Knotek 77). The variables can then elucidate the present change in the rate of unemployment on the left part.
In conclusion, Okun law has several versions. The first version demonstrates the way change in the rate of unemployment between quarters shifted with quarterly increase in real output. This first version depends on readily available macroeconomic statistics. Conversely, Okun’s second relationship links the unemployment level to the gap amid actual output and potential output.
The dynamic version holds the principle that both current and previous output can affect the present height of unemployment. Lastly, production-function versions of Okun’s law, merges a hypothetical production function to create output, using the gap-based version of the law. These versions keep away from entailing powerful and, occasionally, contentious assumptions concerning the description and calculation of full employment and potential output.
Cuaresma, Jesus. “Okun’s Law Revisited.” Oxford Bulletin of Economics and Statistics 65.4(2003): 439–451.Print.
Knotek, Edward. “How Useful is Okun’s Law?” Economic Review (2007): 73-103. Web.
Prachowny, Martin. “Okun’s Law: Theoretical Foundations and Revised Estimates.” Review of Economics and Statistics 75.2(1993): 331–336.Print.