Okun’s Law: What is the relationship between employment and economic growth?

Since in 1962, an American economist establishes a correlation between employment and inflation, the study of Okun’s law is still very valid. Many are those who question its validity, while other organizations indicate a certain usefulness.

When economists speak, they, on many occasions, present a series of opinions that, full of complex terms, can confuse the population after their presentation. Among these concepts, economists tend to use the concept “variable” a lot; Therefore, based on the fact that we are talking about a science with a notable and substantial mathematical component, the models used, which try to simplify study and observation, are full of these “variables”. That is, symbols that represent a certain concept that can take different numerical values.

In other words, the variables try to represent, as we say, a certain concept. So let’s imagine that we want to measure the relationship between unemployment and inflation. In this case, and with the help of the Phillips curve, models are established that relate these two variables, for this example unemployment and inflation, as the main ones and those that we want to correlate, as well as the other variables that in the analysis we can analyze; these others being the aggregate demand, for example.

In summary, variables that after the analysis can present correlation, although this does not imply causality, as economists also say, and in this way, show us who are trying to investigate this exciting science, and we enter this world of numbers and letters , how a certain variable impacts another, and how we should act about it, or at least, how we should. And it is that, in the article that we publish today, we talk about two variables that, through Okun’s law, have been constantly correlated throughout history.

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And about this, gentlemen, we talk in today’s article. Let’s look at this interesting theory.

A very reliable law

First of all, and paying our respects to orthodoxy with the utmost rigor, it should be noted that this “law” is only an empirical observation, since it cannot be demonstrated. Okun himself warned that this theory is only effective when the unemployment rate is between certain parameters. Therefore, when we talk about the relationship between growth and unemployment, we must bear in mind that Okun’s law is not everything, and we must complement our study with other models, observations, indicators, as well as all kinds of tools that allow increasing the thoroughness, and objectivity, of our research.

Okun's Law Example
Example of a graph representing Okun’s law

According to the Law, Arthur Okun tells us that there is a correlation between changes in the unemployment rate and the growth of an economy. In this sense, the economist pointed out that, to maintain certain employment levels, an economy needed to grow each year at a rate of between 2.6% and 3%. Any lower growth, for the economist, meant an increase in unemployment, due to an improvement in productivity.

In the same way, this law also indicates that, once the level of employment has been maintained, thanks to that required growth of 3%, in order to reduce unemployment it is necessary for the economy to grow, according to the author of said law. , two percentage points for each point of unemployment to be reduced.

To establish this correlation, Arthur Okun drew on data from the 1950s, looking at the case of the United States. In addition, it is worth noting those warnings that we made before, and that even Okun himself communicated after the publication of his observation. And, in the same way that a correlation was observed, it warned of limitations in this theory, such as the fact that it is only effective when the unemployment rate is at levels between 3 and 7.5%. Taking into account the heterogeneity of countries worldwide, this law has been questioned due to the fact that the levels proposed by Okun are not the same in all economies. In addition, these depend on the period analyzed, and, as we say, the country that we want to investigate.

Despite the criticism, since we are talking about a law that has been harshly questioned by many academics, given the previous justifications and that they are completely valid, the truth is that everyone recognizes that this rule has been approximately fulfilled in most of the cases analyzed. For this reason, we say that Okun’s law is a law that is considered a very reliable observation in macroeconomics.

Very justified nuances

The renowned economist of the Bank of Spain, and editor of the economic blog Nada es Gratis, Juan Francisco Jimeno, is a renowned student of the behavior of employment in the peninsular country. In his book “growth and employment, a turbulent and misunderstood relationship” (editorial RBA), he publishes the following statement:

“In the previous five chapters we have seen that the relationship between economic growth and job creation is quite complex: it varies over time and between countries; It depends on the time horizon that is considered; contradicts simple calculations that seem like common sense; and it is conditioned by the behavior of a macroeconomic variable, productivity growth, about which, in reality, we know little ”.

To begin with, it is worth pointing out the widespread fallacy that there is a fixed amount of employment. A fallacy for which some politicians propose early retirement, as long as life expectancy increases, so that young people can enter the labor market to replace those who retire. But this, as I say, is the beginning of many nuances that could be said about this law.

In the same way, the economist, a professor at the University of Alcalá, confirms what has been said above, since we are talking about a law that will make sense depending on the country analyzed, as well as the period observed. For this reason, despite how interesting this law is, and that we talk about the fact that it is sometimes complied with, we must emphasize that there are limitations and that generalizing with this law, even if the statistics accompany the one who coined it, can lead us to commit diagnostic errors and, as the author of the work points out, applying useless policies that only aggravate the situation.

The IMF notes its existence

According to the multilateral organization, the International Monetary Fund (IMF), the link between employment and economic growth does not always follow a direct line in the countries, as we said at the beginning, but that does not mean that it does not exist.

In this sense, the agency shows us that Okun’s law is generally complied with in the case of the United States, although it is also observed that, since 2011 and after the strong job losses registered during the 2008 crisis, this relationship that We explain has deviated significantly from the historical trend.

In other countries such as Australia or Canada, according to the agency, an increase of 1% in GDP is related to an increase in employment of 0.6% or even more. Although, in the same way and taking into account these limitations mentioned at the beginning, and pointed out by the renowned economist Juan Francisco Jimeno, this relationship does not present notable results in countries such as China, Turkey or Indonesia. Thus, the agency shows this limitation after concluding that, while GDP growth represents more than 70% of the variation in employment in Canada or the United States, in other countries such as Russia or the United Kingdom it represents 40%.

In summary, in the same way that the statements of the economist and many academic authors are fulfilled, taking into account this distinction when measuring one country or another, the truth is that, for most countries, taking into account the growth in The analysis is of great importance to understand the variations of unemployment in the short term. For this reason, we are talking about a law that still has much to contribute to the economy, and that requires more observations to not only improve the mechanisms that allow us to link some variables with others, but also to try to improve the application of some policies that in cases such as Spain and as the author cited in the article says, they only generate dysfunctions in a labor market that is very misunderstood by society, and even by many economists.

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