- Arthur Okun, a Yale professor and economist, proposed Okun’s law in the early 1960s.
- Okun’s law examines the statistical relationship between unemployment and economic growth rates in a country.
- According to Okun’s law, a country’s gross domestic product (GDP) must expand at a pace of around 4% for one year in order to achieve a 1% reduction in unemployment.
What is the link between unemployment and real GDP?
Employment will rise as long as growth in real gross domestic product (GDP) outpaces growth in labor productivity. The unemployment rate will fall if employment growth outpaces labor force growth.
What’s the link between GDP growth and unemployment?
Jordan is short on natural resources, although the rest of Middle Eastern countries have plenty of oil, gas, and other minerals. One of the key causes for Jordan’s low GDP is a scarcity of resources. Jordan’s low GDP is also due to low national income and limited investment as a result of high tax rates. When the unemployment rate is reduced, the economy will be operating at full capacity, and it will be powerful as consumption and purchasing power increase.
Jordan has a large population and is one of the most educated countries in the area, particularly among the youth. The most important reasons for unemployment are: first, the young Jordanians have been educated in a field that does not match the demand for labor in the market (supply of labor cannot respond to the demand for labor), second, the high ratio of foreign labors working at the minimum wage (which reduces the demand for local labor), and third, the public sector’s weakness and lack of public investment.
The relationship between economic growth and unemployment reveals that the rate of economic growth and the reduction in unemployment rates are highly correlated. An rise in the growth rate leads to an increase in employment or a decrease in unemployment. The relationship between economic growth and unemployment has been explored empirically in the economic literature based on the Okun law, which states that the change in the growth rate (GDP) and the change in the unemployment rate are inversely related. Okun has demonstrated the existence of a reciprocal relationship between unemployment and economic growth. He discovered that if unemployment fell by 1%, it was owing to a 3% increase in real gross domestic product (RGDP), and vice versa, with an increase in RGDP resulting in an increase in employment.
Economic growth is the primary goal of governments, as it is a measure of wellbeing, living standards, and poverty reduction. Using Okun’s law, certain research have empirically explored the relationship between economic growth and unemployment. Al-Habees employed a simplified model of Okun law to investigate the relationship between unemployment and economic growth in different Arab nations, with Jordan as the major case study. The findings revealed a substantial relationship between growth and shifting unemployment rates, as well as the effectiveness of economic strategies aimed at reducing unemployment while maintaining a balanced pace of economic growth. In addition, Kreishan, using Okun’s law and Augmented DickeyFuller (ADF) for unit root over the period 19702008, discovered that a lack of economic growth in Jordan does not explain the unemployment phenomenon.
Using ECM and ARDL Johansen cointegration tests, Akeju and Olanipekune investigated the Okun’s law in Nigeria to analyze the linkage between unemployment and economic growth, resulting in a notable linkage between unemployment and economic growth.
Between 1994 and 2010, Abdul-khaliq examined the relationship between unemployment and GDP growth in nine Arab countries. He discovered that growth had a notable negative effect on unemployment rates, as well as a positive association between population growth and unemployment rates. Rahman investigated the association between GDP, GDP per capita, literacy rate, and unemployment rate in OECD countries and discovered that GDP, GDP per capita, literacy rate, and unemployment rate are not significantly associated.
Using simple linear regression, Khrais and ve Al-Wadi investigated the relationship between economic growth and unemployment in MENA nations from 1990 to 2016, finding a weak correlation between the variables. Alawin used the ADF test and Johansen’s co-integration to show the link between the trade balance and the unemployment rate in Jordan over a thirteen-year period from 2000 to 2012, and he understood that a decline in the trade balance can increase the unemployment rate, and unemployment can have a negative effect on the trade balance in the short-run.
Nageld looked into the relationship between GDP growth and unemployment and discovered that the two have a negative relationship. Furthermore, Ahmed used OLS to examine the relationship between unemployment rate and growth rate in selected SAARC countries (Bangladesh, Bhutan, India, Pakistan, and Sri Lanka) from 1990 to 2010, and discovered a sign of the correlation between the economic growth rate and unemployment rate differs between the SAARC countries.
Following that, Ali and Allan stated that, from 1991 to 2015, economic growth had a positive and statistically significant impact on unemployment in Jordan. Using the OLS technique, Moh’d AL-Tamimi and Mohammad (2019) investigated the impact of the unemployment rate on economic growth in Jordan between 2009 and 2016, finding that the unemployment rate (in total labor) had a negligible impact on economic growth.
Magnani aimed to extend the Solow model, which may explain unemployment as a shortfall of aggregate demand, with an increase in aggregate demand reducing unemployment and catalyzing GDP growth. From 1994 to 2017, Xesibe investigated the impact of unemployment on GDP growth in South Africa. The findings revealed that in South Africa, there is a negative relationship between unemployment and economic growth.
Finally, Ojima investigated the relationship between unemployment and economic development in Nigeria for 35 years, from 1980 to 2017, and discovered that unemployment harmed Nigeria’s economic development, with an adverse linkage between unemployment and economic development, and recommended a fiscal and monetary policy to create job opportunities in order to sustain Nigeria’s economic growth. In the long run, Dahmani discovered a negative association between the variables, whereas in the short run, there was no correlation between unemployment and economic growth in Algeria from 1970 to 2014.
Is a higher GDP associated with reduced unemployment?
The COVID-19 epidemic has caused cities and regions across the United States to shut down. Many states have issued or are considering issuing stay-at-home orders, which require most non-essential businesses to close and citizens to stay at home. These measures are intended to delay or halt the spread of COVID-19 by limiting inter-person interaction and thereby minimizing exposure and infection risks. The production of the US economy will drop drastically as most non-essential firms close, and the unemployment rate will rise dramatically. Jobless claims are already pouring in from all around the country.1
Is it really that bad? We’ve seen various estimates of negative GDP growth rates and jobless rates that have skyrocketed. One of the most recent projections comes from Goldman Sachs, which is downgrading the GDP growth rate from 24% to 34%, with a 15% unemployment rate. 2 Because these numbers are unprecedented, it will be difficult to impose discipline on them, based on past experience.
By merging data from the Bureau of Labor Statistics (BLS) and the Bureau of Economic Analysis, this essay aims to discover a link between GDP growth rates and unemployment rates (BEA). The BLS’s employment requirement table gives a thorough estimate of the number of employees necessary for each industry or sector to produce $1 million in output. In addition, the BEA publishes a breakdown of GDP across several sectors and industries. As a result, we can calculate a link between the GDP growth rate and unemployment rates using the BLS employment database and the BEA’s industry-level GDP. The GDP in the second quarter of 2019 was used to make this calculation.
The closure of the economy has had little impact on some industries and sectors. Assume that the outputs of these sectors remain unchanged from those of 2019. Agriculture, government, housing, hospitals, and grocery shops are among these industries (such as supermarkets). These industries contribute for 30% of overall GDP in the United States.
Furthermore, certain industries are more labor-intensive than others, implying that the quantity of labor required to create the same amount of output is higher in some industries than in others. As a result, if the GDP loss comes from more (less) labor-intensive industries, the unemployment rate is higher (lower). As a result, there are upper-bound (blue line) and lower-bound (red line) estimates of unemployment rates conditional on the GDP growth rate being reduced, as seen in the graph. The upper bound assumes that the decline in GDP (represented on the x-axis) moves from the most labor-intensive to the least labor-intensive sectors. The lower bound, on the other hand, assumes the inverse.
Given that the unemployment rate in the second quarter of 2019 was around 3.6 percent, both lines begin with unemployment rates of 3.6 percent, assuming that GDP remains constant. If all output from these afflicted industries disappeared (up to 70% of GDP), the jobless rate would skyrocket to 76 percent. If the GDP growth rate is 34 percent, Goldman Sachs’ estimated unemployment rate appears to be low, according to this computation. More specifically, the unemployment rate should be between 26% and 51%, resulting in a GDP decrease of 34%.
My calculation aims to bring some order to the wild forecasts of future GDP and unemployment rates. Obviously, there are several caveats to my calculation. First, it is predicated on the premise that some industries, which account for 30% of GDP, will remain unaltered. Some firms’ employment or output (for example, grocery stores or Amazon) may be increased as a result of the economic shutdown. Furthermore, there are a slew of variables that could skew this estimate, perhaps lowering the unemployment rate. Because companies expect a speedier rebound in the third quarter and do not want to lose their workers, it is quite likely that the unemployment rate will respond slowly to the steep decrease in GDP. The extension of unemployment benefits (as authorized by Congress) could, on the other hand, stimulate layoffs and raise the unemployment rate.
How are the unemployment rate and gross domestic product calculated?
As a result, the output gap (the difference between Actual and Potential GDP) divided by Potential GDP equals the negative Okun coefficient (negative denotes an inverse link between unemployment and GDP) multiplied by the change in Unemployment.
If we follow traditional Okun’s law, the Okun coefficient will always be 2. However, in today’s context, this coefficient will not always equal two and may vary depending on economic conditions.
What effect does the interest rate have on unemployment?
When inflation is expected to exceed the central bank’s target, interest rates are frequently raised. Higher interest rates have the effect of slowing economic growth. Higher interest rates raise the cost of borrowing, lower disposable income, and so limit consumer spending growth. Higher interest rates lower inflationary pressures and cause the currency rate to appreciate.
Effect of higher interest rates
- Borrowing costs rise as a result. Interest payments on credit cards and loans are more expensive when interest rates rise. As a result, people are less likely to borrow and spend. People who already have loans will have less discretionary income since interest payments will take up more of their income. As a result, consumption in other areas will decrease.
- Mortgage interest costs will rise. The fact that interest payments on variable mortgages will rise is related to the first point. Consumer spending will be affected significantly as a result of this. This is because a 0.5% increase in interest rates can raise the monthly cost of a 100,000 mortgage by 60. This has a big impact on people’s discretionary income.
- Increased motivation to save instead than spend. Because of the return earned, higher interest rates make it more appealing to save in a bank account.
- Higher interest rates boost a currency’s worth (Due to hot money flows, investors are more likely to save in British banks if UK rates are higher than other countries) A stronger Pound reduces the competitiveness of UK exports, resulting in lower exports and higher imports. This has the effect of lowering the economy’s aggregate demand.
- Consumers and businesses are both affected by rising interest rates. As a result, consumption and investment are projected to shrink in the economy.
- Interest payments on government debt are increasing. The UK pays almost 30 billion a year in interest on its national debt. The cost of government interest payments rises when interest rates rise. This could result in future tax increases.
- Reduced self-assurance. Consumer and business confidence are affected by interest rates. Interest rate hikes discourage investment by making businesses and consumers less eager to make risky investments and purchases.
As a result of increasing interest rates, consumer expenditure and investment are likely to fall. As a result, Aggregate Demand will decrease (AD).
- Unemployment is higher. Firms will manufacture fewer things and, as a result, demand fewer people if output falls.
- The present account has improved. Higher rates will limit import expenditure, but lower inflation will aid enhance export competitiveness.
Evaluation of higher interest rates
- Higher interest rates have a variety of effects on people. Higher interest rates have a different impact on different consumers. Rising interest rates will disproportionately harm those with large mortgages (typically first-time purchasers in their 20s and 30s). For example, lowering inflation may necessitate raising interest rates to a point where those with huge mortgages face significant hardship. Those with savings, on the other hand, may be better off. As a macroeconomic tool, monetary policy becomes less effective as a result.
- Time-lags. It can take up to 18 months for the effects of increased interest rates to be felt. For example, if you have a 50% completed investment project, you are likely to complete it. Higher interest rates, on the other hand, may deter the start of a new project in the coming year.
- It is dependent on the economy’s other components. A rise in interest rates may have less of an impact on limiting consumer spending growth at times. For example, if property prices continue to climb at a rapid pace, consumers may feel compelled to continue spending despite rising interest rates.
- The rate of interest in real terms. It’s vital to remember that the actual interest rate is the most important factor. Nominal interest rates minus inflation equals the real interest rate. If interest rates rise from 5% to 6%, but inflation rises from 2% to 5.5 percent, This translates to a reduction in real interest rates from 3% (5-2%) to 0.5 percent (6-5.5) As a result, the rise in nominal interest rates represents expansionary monetary policy in this situation.
- It depends on whether or not interest rate increases are passed on to consumers. Bank profit margins may be reduced while commercial rates remain stable.
- Expectations. If individuals assume low interest rates when they unexpectedly rise, they may find themselves unable to afford mortgages or loans. People have grown accustomed to low rates after several years of zero interest rates.
US interest rates
Increased interest rates between 2004 and 2006 had a substantial impact on the home market in the United States. Mortgage defaults increased as mortgage costs rose, exacerbated by the huge number of sub-prime mortgages issued during the housing bubble.
Higher interest rates were a major influence in the burst of the housing bubble and subsequent credit crisis in this scenario.
Interest rates and recession
A recession can be triggered by rising interest rates. A dramatic rise in interest rates has triggered two major recessions in the United Kingdom.
Interest rates were raised to 17% in 1979/80 as the new Conservative government attempted to keep inflation under control (they pursued a form of monetarism). The UK went into recession in 1980 and 1981 as a result of rising interest rates and Sterling appreciation. (See 1981 Recession) Interest rates were also raised to 15% to combat excessive inflation in the late 1980s (and to maintain the value of the pound in the ERM).
The Bank of England / Federal Reserve sets the primary interest rate (base rate). If the Central Bank is concerned that inflation will rise, it may opt to raise interest rates in order to limit demand and slow economic growth.
When the central bank raises interest rates, it usually means that commercial rates will rise as well. Take a look at how interest rates are determined.
What happens to real income when real GDP rises?
Finally, evaluate the consequences of a rise in real gross domestic product (GDP) (GDP). Such an increase indicates that the economy is growing. As a result, looking at the implications of a rise in real GDP is the same as looking at how interest rates will change as a result of economic expansion.
GDP may rise for a variety of causes, which will be examined in more detail in the next chapters. For the time being, we’ll assume that GDP rises for no apparent reason and explore the implications of such a development in the money market.
Assume the money market is initially in equilibrium with real money supply MS/P$ and interest rate i$ at point A in Figure 18.5 “Effects of an Increase in Real GDP.” Assume, for the sake of argument, that real GDP (Y$) rises. The ceteris paribus assumption states that all other exogenous variables in the model will remain constant at their initial values. It means that the money supply (MS) and the price level (P$) are both fixed in this exercise. People will need more money to make the transactions required to purchase the new GDP, hence a growth in GDP will enhance money demand. In other words, the transactions demand effect raises real money demand. The rightward change of the real money demand function from L(i$, Y$) to L(i$, Y$) reflects this rise.
When the GDP drops, What happens if you’re unemployed?
During the recent recession, the observed drop in GDP was accompanied by a larger increase in the unemployment rate than Okun’s formula predicted. With only a 0.5 percent drop in GDP, the unemployment rate increased by 3 percentage points in 2009:Q4 compared to 2008:Q4. However, according to Okun’s formula, that 0.5 percent loss in GDP should have resulted in a 1.5 percent increase in the jobless rate. In 2011, the trend is reversed: Q4: A slight gain in GDP was accompanied by a drop in unemployment that was much higher than the data’s pre-Great Recession connection would have anticipated. While the economy increased by less than 2% (green circle), the unemployment rate fell by one percentage point. Okun’s law, on the other hand, anticipated a 0.5-percentage-point increase in unemployment. The relationship between 2009:Q4 and 2011:Q4 is depicted by the red line in the first graph: A four-percentage-point increase in the unemployment rate equals a one-percentage-point drop in output. As a result, the most recent trend is substantially steeper than previous ones.
What effect does faster real GDP growth have on unemployment?
What effect does faster real GDP growth have on unemployment? Faster real GDP growth lowers unemployment.
Is employment good for the economy?
By increasing GDP, creating jobs benefits the economy. When someone is employed, they are compensated by their employer. As a result, they have more money to spend on food, clothing, entertainment, and other things. The more money a person spends, the higher the demand. Companies boost their output to fulfill growing demand for a product or service when demand rises. Companies achieve this by increasing their investment and hiring more employees. More workers enter the cycle, resulting in even more money being spent in the economy, further increasing demand.
According to Okun’s law, what is the link between real GDP and unemployment?
According to Okun’s law, if real GDP growth exceeds trend, unemployment will decrease.