Question

e) Okun's Law - full statement of Okun's law and how to write an equation to represent it. 1) How to use Okun's law to calculate the output gap, real output, or potential output given the necessary information g) How to interpret the output gap in percentage form (i.e. what the output gap represents).

please help me out

Answer 1

An article written by Okun in the year 1962 became the base of an empirical relationship between the rate of unemployment and the national output, or the Gross National Product. The law indicates a 3% point increase in output for every 1 point reduction in the unemployment rate, but with the other factors remaining constant, the rise in the number of labor the productivity increases as well.

The full statement according to Martin F.J. Prachowny (Martin F. J. Prachowny. (1993). Okun's Law: Theoretical Foundations and Revised Estimates. The Review of Economics and Statistics, 75(2), 331-336. doi:10.2307/2109440) -

Okun's promise of "large rewards" to any reduction in unemployment can, however, be misleading because he assumed that other factors would change pari passu with the unemployment rate and that the coefficient of three captured the combined effect of all influences on output. He wrote: Clearly, the simple addition of 1 percent of a given labor force to the ranks of the employed would increase employment by only slightly more than 1 percent... If the workweek and productivity were unchanged, the increment to output would be only that 1+ percent. The 3 percent result implies that considerable output gains in a period of rising utilization rates stem from some or all of the following: induced increases in the size of the labor force; longer average weekly hours; and greater productivity. (1970, p. 140, emphasis added.) His subsequent calculations led him to the following conclusion: (A) 1 percentage point reduction in the unemploy- ment rate will also be accompanied by an increase of nearly 0.5 percent in hours per man, or an addition of 0.2 of an hour per workweek. With an allowance for induced gains in the labor force (of 1.3%]'...manhour productivity must rise by 1.4 percent. (1970, p. 142, emphasis added.)

The equation is -

The relationship between unemployment changes and output must be derived from a production function for the economy as well as from ancillary relationships in the labor market. In natural logs, the production function is written as y = a(k + c) + Blyn + 8h) +

The gap version of the Okun's Law is as follows -

Unemployment rate = c + d ∗(Gap between potential output and actual output).

Where "c" is interpreted as the unemployment rate associated with full employment. The "d" should be positive.

To calculate the real output -

The black regression line shows the estimated difference version of Okun’s law: Change in the unemployment rate = 0.23–0.07 ∗(Real output growth).

To calculate the potential output -

ΔU Y t t = β (Δ − µ) where ∆U is the change in the unemployment rate, ∆Y is growth in log GDP (typically represented in terms of annualized percentage changes) and µ is the rate of GDP growth consistent with stable unemployment.

To interpret the output gap in percentage form, the percentage GDP gap is the actual GDP minus the potential GDP divided by the potential GDP.