What is Okun’s Law? How does it describe the relationship between GDP and unemployment rate?
The correct answer and explanation is:
Correct Answer:
Okun’s Law describes an inverse relationship between a country’s unemployment rate and its real Gross Domestic Product (GDP). Specifically, for every 1% increase in the unemployment rate, a country’s real GDP falls about 2% below its potential GDP.
Explanation:
Okun’s Law is an empirical observation made by economist Arthur Okun in the 1960s. It provides a practical way to link changes in unemployment to the performance of the economy. The law states that when unemployment rises, economic output falls, and when unemployment decreases, output increases. This connection arises because labor is a key input in production. When fewer people are working, fewer goods and services are produced.
The standard version of Okun’s Law is expressed mathematically. For every 1 percentage point increase in the unemployment rate above the natural rate, GDP falls by approximately 2 percent relative to its potential. This ratio is not fixed but gives a general estimate of the relationship.
For example, if the unemployment rate increases from 5% to 6%, real GDP may fall roughly 2% below what it could have been if full employment were maintained. This happens because more unemployment means fewer workers producing output, leading to slower economic growth.
Okun’s Law also highlights the cost of unemployment to the economy. High unemployment not only reflects unused labor but also implies underutilized capital, reduced consumer spending, and lower business profits. It shows that reducing unemployment can stimulate economic growth and vice versa.
Although useful, Okun’s Law is not a precise rule. The actual relationship between unemployment and GDP can vary depending on labor productivity, technological changes, and structural shifts in the economy. Nonetheless, the law remains a valuable tool in understanding how labor market conditions impact overall economic performance.