US / Okun’s Law says the economy is well below its potential

Half a century ago, when business cycle research was blossoming, Arthur Okun explored the relation between GDP and unemployment during periods of recession and recovery. As a first approximation, one might have assumed that a one percent decline in output would be associated with roughly a one percent decline in employment and a one point rise in the unemployment rate. However Okun showed that this approximation was very wide of the mark. In what came to be known as Okun’s Law, he estimated that a one percentage point higher unemployment rate was associated with three percent less GDP. Thus if unemployment was 2 points above its full employment level, GDP would be 6 percent below its potential level-defined as the level of GDP at full employment.

The building blocks of Okun’s Law were several cyclical features of the economy and its job market. In a weak job market, many discouraged workers stop looking for jobs and thereby leave the labor force. So a cyclical decline in employment does not produce a corresponding increase in measured unemployment. Cyclical movements in aggregate output per worker also reduce the impact of GDP fluctuations on the unemployment rate. In part this comes because a disproportionate part of cyclical job loss come in high productivity industries like manufacturing. And in part it comes because, in all industries, firms experience procyclical variations in output per worker because many jobs have the characteristics of “overhead” labor—they are needed if the firm is in business at all rather than in proportion to the firm’s level of output. And even for production workers, whose jobs are closely tied to the level of current output, most firms vary hours worked per week as a buffer against layoffs.

The basic logic that underlies Okun’s law has proven to be robust over the decades. But the declining share of manufacturing in total employment and other changes in the structure of the economy have gradually altered the size of the cyclical effects. In recent decades, the Okun’s Law parameter, which had been 3 in the early postwar decades, has more recently been around 2.

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via Okun’s Law Says We’re Growing Well Below Our Economic Potential | Brookings Institution.