Question

Define Okun’s Law. How does it connect to real GDP, unemployment and opportunity cost. How is it connected to the business cycle?Define Okun’s Law. How does it connect to real GDP, unemployment and opportunity cost. How is it connected to the business cycle?

Answer 1

Okun's Law: Economic Growth And Unemployment

The economic growth and employment are the two related concepts of an economy. There a real and direct relationship between the GDP and unemployment levels. Okun first started his theoretical analysis on GDP and unemployment in 1960’s and his research on the subject is known as Okun’s Law.

The basis of Okun’s Law is that it investigates the statistical relationship between country’s unemployment and the growth rate of the economy. It tells that how much a country’s gross domestic product be lost when the unemployment rate is above it’s natural rate. The law explains that the output depends of the amount of labour used in production process. Hence there is positive relationship between output and employment. The total employment of the economy is equal to total labour force minus the unemployed. There is a negative relationship exist between output and unemployment.

Okun observed the relationship between the changed in unemployment rate and the growth rate in real GDP. Because of the steady increase in the size of labour force, real GDP growth rate must be close to its required potential to hold the employment rate steady. In other words, to reduce unemployment rate the economy must grow at a pace above its potential.

Okun says that to achieve a 1% point decline in the unemployment during a year, needs the real GDP to grow at approximately 2% faster than the potential GDP. In other words to achieve 1% decline in unemployment the real GDP must grow at 4% over the year.

Okun’s law clearly state that when unemployment falls by 1% GNP rises by 3%. Another version of Okun’s law is that it focuses on the relationship between unemployment and GDP. 1% increase in unemployment causes 2% fall in GDP.

The business cycle is the pattern of expansion, contraction and recovery in the economy. Generally speaking, the business cycle is measured and tracked in terms of GDP and unemployment – GDP rises and unemployment shrinks during expansion phases, while reversing in periods of recession. Wherever one starts in the cycle, the economy is observed to go through four periods – expansion, peak, contraction and trough.

Recession is typically used to mean a downturn in economic activity, but most economists use a specific definition of "two consecutive quarters of declining real GDP" for recession. By comparison, there is no formal definition of depression. While recessions have averaged around 10 months in length since the 1950s, the recovery/expansion phases have a much wider range of lengths, though around three years is relatively common.

The movement of the economy through business cycles also highlights certain economic relationships. While growth will rise and fall with cycles, there is a long-term trend line for growth; when economic growth is above the trend line, unemployment usually falls. One expression of this relationship is Okun's Law, an equation that holds that every 1% of GDP above trend equates to 0.5% less unemployment.

The relationship between inflation and growth is not as clear, but inflation does tend to fall during recessions and then increase through recoveries.
While the business cycle is a relatively simple concept, there is great debate among economists as to what influences the length and magnitude of the individual parts of the cycle, and whether the government can (or should) play a role in influencing this process. Keynesians, for instance, believe that the government can soften the impact of recessions (and shorten their duration) by cutting taxes and increasing spending, while also preventing an economy from "overheating" by increasing taxes and cutting spending during expansion phases.

In comparison, many monetarist economists disagree with the notion of business cycles altogether and prefer to look at changes in the economy as irregular (non-cyclical) fluctuations. In many cases, they believe that declines in business activity are the result of monetary phenomena and that active government inflation is ineffective at best and destabilizing at worst.

There are numerous other alternate theories on the business cycle and its causes/influences. Real business cycle theorists, for instance, believe that it is external shocks like innovation and technological progress that drive cycles, and that issues like excessive overcapacity can drive downturns. Other theorists suggest that excess speculation or the creation of excess levels of bank capital drive business cycles.

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