Okun’s Law describes a relationship in economics between unemployment and economic output, such that when unemployment falls GDP increases, and when unemployment rises, GDP decreases.
Context: Okun’s law is named for Arthur Okun of the 1960s.
The law states that for every 1% decrease in the unemployment rate, a country’s GDP will be roughly 2% higher than its potential output. Conceptually, this relationship means that as people find jobs, they contribute to economic production of goods and services, and vice versa—Okun’s Law quantifies that reasonable premise.
Here’s a graph looking at the relationship in unemployment versus output (real GDP) growth in the U.S:
Natural unemployment is always above 0% given frictional and structural unemployment, so Okun’s law can be expressed mathematically as follows (then we’ll break it down):
(Y* — Y)Y* = c(u — u*)
Where:
Y* = potential GDPY = actual outputc = constant that relates changes in unemployment to changes in outputu = actual unemployment rateu* = natural unemployment
Note that u-u* simply adjust unemployment for natural unemployment, and should be a simple calculation like 3% – 1.2%. c is the 2% number we just described, whereas for every 1% decrease in unemployment we empirically see a rough 2% increase in GDP potential. Since 2% is observed and not a hard rule, we’re generalized it to the weighting factor “c.” The GDP gap (also called the output gap), or (Y* — Y)/Y* reflects how an economy could be doing compared to how it’s doing. A positive gap means actual output exceed potential output, suggesting inflation or an overheating economy. A negative gap indicates that actual output is below potential output, meaning resources are being underutilized. So, generally, a GDP gap of zero is a good thing.
Here’s a numeric example solving for potential GDP:
Current GDP = 3%Unemployment Rate = 2%Natural unemployment rate = 1%c = 2%
(Y* — Y)Y* = c(u — u*)
(Y* — 0.03)Y* = 0.02(0.02 – 0.01)
(Y* — 0.03)Y* = 0.02(0.01)
(Y* — 0.03)Y* = 0.0002
**quadratic formula math which I’ll remove for sake of brevity.
Y* = 0.035615
Thus, potential GDP = 3.56%. Since current GDP is 3%, we can see that this economy is slightly underutilized and has more growth-rate room to run.
Hope you found it helpful! Here’s another article detailing nominal and real GDP (here), and one more about how to calculate inflation using multiple GDP deflators (here). Also:
Read about the Income Approach to GDP here.Read more economics stories here.To learn more about the oil market, consider reading about PADD Districts, the Why WTI and Brent are Crude Oils, and Why There are Price Differences Among Crude Oils, and my Oil & Gas Terms Guide.