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Okun's Law

Key Economic Concepts:

• Macroeconomic Indicators

Description:

The students sharpen their graphing skills by interpreting the relationship between changes in the unemployment rate (%) and real GDP. From this graph, students will determine the natural rate of GDP growth for the U. S. Economy since 1960. They draw the linear relationship between the change in unemployment and GDP and interpret their graphs.

Lesson Objectives:

Students will:

• Interpret a scatter plot containing the change in unemployment on the Y-axis and GDP growth on the X-axis.
• Determine the natural growth rate of GDP.
• Use Okun's Law to write an equation relating the change in X to the change in Y.
• Make predictions on output growth, given a positive or negative change in the unemployment rate.

Introduction:

This lesson will help students understand relationships among output, unemployment, and inflation. The students will see that a 1% increase in the unemployment rate does not diminish real GDP by 1%. They will learn that the economy must grow at a rate of 3% for the unemployment rate to remain unchanged. At a natural GDP growth of 3%, the economy is at potential output and in the long-run equilibrium. In addition, unemployment and GDP data have been rearranged to derive the natural rate of unemployment or NAIRU.

Resources:

• Okun's Law: Okun's law refers to the relationship between increases in unemployment and decreases in a country's gross domestic product (GDP ). It states that for every one percent increase in unemployment above a "natural" level, that GDP will decrease by anywhere from two to four percent from its potential. Okun's law is named after Arthur Okun, the economist who in 1962 was the first to make detailed observations about this relationship. So-called "natural unemployment" refers to the fact that there will always be at least a certain amount of unemployment in a free market economy , because of voluntary changes in employment, and other reasons not related to economic hardship.
  www.wisegeek.com/what-is-okuns-law.htm ^[1]
   
• GDP Prediction: A prediction of future GDP can be seen at this website.
  http://mikeroeconomics.blogspot.com/2009/06/growth-rate-form-of-okuns-law.html ^[2]
   
• Lesson Concepts (NAIRU Video): The concepts of the lesson are shown in a 2:58 video by the author.
  This video by Mike Fladlien discusses the natural rate of unemployment.
  NAIRU Video
   
• Okun's Law Worksheet Activity.
  www.econedlink.org/lessons/docs_lessons/848_Okun's%20Law%20WS1.pdf
   
• Okun's Law Worksheet Activity KEY.
  www.econedlink.org/lessons/docs_lessons/848_Okun%20Law%20ANSWER%20KEY1.pd

• "The Sun Also Rises": August 6, 2009. WASHINGTON, DC. From The Economist print edition. The economy may be pulling out of recession but unemployment is still surprisingly high. Celebrations should be delayed.
  http://gregip.wordpress.com/2009/08/06/signs-of-economic-cheer-the-sun-also-rises/ ^[3]

Process:

Explain each of the relevant vocabulary words:

• Unemployment Rate: The number of unemployed people, expressed as a percentage of the labor force.
• Labor Force: The people in a nation who are aged 16 or over and are employed or actively looking for work.
• Okun's Law (Relation): A 1% change in the unemployment rate results in a 2% change in real GDP
• Natural GDP Growth Rate: a 3% GDP growth rate is consistent with full employment
• Natural Rate of Unemployment: Frictional plus Structural unemployment. The Congressional Board Office estimates this rate at 5.2%
• NAIRU: The Non Accelerating Inflation Rate of Unemployment. The same as the Natural Rate - 5.2%
• Equilibrium in the Labor Market: Occurs when the change in the unemployment rate is zero (0)
• Gross Domestic Product (GDP): The market value of all final goods and services produced in a country in a calendar year.

[1] Distribute a copy of the worksheet, "Okun's Law." Have the students identify a cluster of points around the X-axis. [The point they identify should be around the coordinate 3,0.] Explain that when the economy is in equilibrium in the labor market, the change in unemployment is zero. The point they have identified is the natural rate of GDP growth since the change in unemployment is zero.

Project an overhead transparency of the data on a screen or project the data with PowerPoint.

[2a] Plot the ordered pair data from the table on the graph, "Change in Un Vs. GDP". Okun's Law has a slope of -2. Suggestion: have the students use a colored pencil or marker.

[2b] Have the students use a ruler and connect the data points extending the line into quadrants III and IV. This step will enable the students to find the Y-intercept and X-intercept. Making the line extend beyond the Y-intercept and X-intercept makes finding the slope, m, easier.

[2c and 2d] Have the students find the slope using rise/run and derive an equation for the line. [Y = 6 - 2x]

[3] Have the students discuss and answer question three.

[4] Ask the students, "How do changes in the unemployment rate affect the rate of GDP growth?" [When unemployment changes by 1%, GDP falls by 2%. There are three reasons why this is so.] 1) Some workers are needed no matter what. You can't lay off everyone! A firm will still need managers and accountants even if the firm is making less money than it usually does. 2) Training and transaction costs are high. Firms will retain workers by cutting hours, working remaining workers harder, reducing their staff through retirement, or asking workers to use vacation time. 3) When the economy is overheating, not all of the new jobs are filled by the unemployed. Some discouraged workers will be attracted to the labor market. Overall, the interaction of these factors will make interpreting the data complex. Many economists say that Okun's Relation is a better term than "Okun's Law" since the relation comes from an observation of data. Using the line the students have drawn, show that GDP changes by less than unemployment.

[4a] Have the students answer question 4. Give immediate feedback if necessary.

[5] Place a transparency of Okun's Law Gap Version on the overhead or project it by PowerPoint. In this graph, I have plotted the Unemployment rate on the Y-axis and the change in GDP on the Y-axis. A cluster of data points form around 5.8% unemployment when the change in GDP is zero. This shows that 5.8% is the approximate natural rate of unemployment. Have the students discuss this cluster and what it means. Have them complete the table.

[6] Have the student draw the line on the graph of Okun's Law Gap Version.

[7] Have the students compute the slope.

[8] Ask: "If actual unemployment is greater than the natural rate, is the economy producing more or less than the natural rate? (Less. It takes labor to produce output. Since some labor is unemployed, less real GDP is being produced than the potential 3%.] Have the students complete steps 8 and 9. Give immediate feedback.

[9] Ask: "What would happen to prices if there were zero unemployment?" [Prices and wages would skyrocket.] Discuss why some unemployment is good.

Explain that structural plus frictional unemployment equals the natural rate of unemployment. Why is some unemployment, 5.8%, natural? [Frictionally unemployed workers are between jobs, and presumably advancing their careers. Structurally unemployed workers are out of a job because their work has become obsolete. In other words, the economy is creating new jobs while destroying inefficient ones. Economists call this creative destruction. Paul Krugman explains that workers can be structurally unemployed when they receive higher than market clearing wages such as a minimum wage or efficiency wage.]

[10] Review the lesson. (1.) There is a link between GDP, unemployment, and inflation. (2.) When unemployment changes, GDP changes by less. (3.) Okun's law states that a 1% change in unemployment will change GDP by 2%. (4.) The natural rate of GDP growth is 3%. (5.) The natural unemployment rate is 5.8%. (6.) The natural rate of unemployment (or the NAIRU) is approximately 5.8%--where the economy is at full employment.

Conclusion:

When the students have drawn a negative sloped line relating unemployment to real GDP growth, they should discover that the natural GDP growth rate is 3%. They will observe that a 2% change in GDP is associated with a 1% change in employment. There are three reasons why output does not change with unemployment. The students should understand that when the unemployment rate is not changing, the labor market is in equilibrium. When unemployment isn't changing, it is still positive. Some frictional and structural unemployment is healthy for the economy.

Assessment Activity:

1. In 1992 the unemployment rate was 6.9%. In 1993 the unemployment rate was 7.5%. Calculate the change in the unemployment rate._______ [7.5% - 6.9% = .6%]

2. The GDP growth rate in 1992 was 3.3%. Is it close to the natural GDP growth rate in your graph? ______ [Yes.] Explain how your findings support Okun's law. [The unemployment rate of .6%, .006, is very close to zero. This means that there was little or no change in the unemployment rate, so the economy must be at its natural 3% rate.]

3. What are some reasons why output changes less than unemployment? [When unemployment changes by 1%, the effect on output will be less than 1%. There are three major reasons why output doesn't change with unemployment. Labor hoarding happens when employees are worked harder. Firms find it costly to train new employees. When the economy picks up, new job seekers enter the labor market. This would add to the labor force and make the unemployment rate greater. Some economists add the point that technology may have been substituted for labor.]

4. Okun's law predicts what happens to output. Suppose that the government uses both fiscal and monetary policy to decrease unemployment by 1% point from its natural rate. What do economists predict will happen to GDP? [It will be 3.5%. This GDP growth rate is higher than the natural rate. This means that labor resources will be used more intensely. Inflation should follow as resources are relatively scarce.]

5. In this lesson, the author found the natural rate of unemployment to be 5.8%. The Congressional Budget Office estimates the natural rate to be 5.2%. When the economy is at its natural rate, how is inflation changing? [Inflation rate is zero. It is not changing.]

6. What is the Non-Accelerating Inflation Rate of Unemployment? __________ [The NAIRU is the natural rate of unemployment in which there is no change in the unemployment rate. The author estimates this rate at 5.8%. At this rate, the economy is growing at 3%.]

7. What would you expect to happen to prices if the actual rate of unemployment was less than the natural rate? ________ [Prices should increase. NOTE: If the labor market is tight, resources are scarce and workers ask for wage increases. When wages increase, prices follow.]

8. What is the natural rate of unemployment in percent? _______ [Answers can vary. The difficulty of deriving a concrete answer has to do with the changing composition of demographics in the workforce. Estimates range from 5.2% to 6.1%]

Extension Activity:

Have your students read the article, "The Sun Also Rises ^[3] ." After reading, have your students submit a written comment.

[Here is a possible answer. Okun's law expresses the empirical relationship between unemployment and GDP. There are many exogenous variables in unemployment and GDP that Okun's Law does not capture. For example, the amount of unemployment benefits that a worker receives changes the worker's reservation wage. As a result of a higher reservation wage, a worker might search for a job longer and extend the duration of his unemployment. Unemployment benefits are not captured in Okun's Law and as a result, Okun's Law is an empirical relationship on observed data. Students can also address labor migrations, technology, time to retrain employees, structural unemploment, new labor market entrants, and any variable not directly imputed in the equation.]

Links Used:

1. ^{^} "Okun's Law" - (www.wisegeek.com) This site provides a thorough definition of Okun's Law.
2. ^{^} "GDP Prediction" - (mikeroeconomics.blogspot.com) A prediction of future GDP can be seen at this website through a graph and article.
3. ^{^ ^} "The Sun Also Rises" - (gregip.wordpress.com) This site discusses how the economy may be pulling out of recession but unemployment is still surprisingly high. Celebrations should be delayed.

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