Question

Suppose potential output grows 2 percent per year and the natural rate of unemployment is constant at 6 percent. In 2020, the unemployment rate is 7 percent.

a) Assuming Okun's law, what is the output gap in 2020?

b) If output grows 5 percent from 2020 to 2021, what is the unemployment rate in 2021?

Answer 1

A.

According to Okun's law, when unemployment rate goes up by 1%, real output falls by 2%.

Here, unemployment is 1% higher than the natural level. So, the GDP will be 2% lower than the potential level. So, the outptu gap would be 2%.

B.

According to Okun's law, when unemployment rate goes up by 1%, real output falls by 2%.

So, 5% output growth would result in fall un unemployment by 5%/2 = 2.5%

So, the unemployment rate would be 7% - 2.5% = 4.5%