Economic Growth and Unemployment: a Reappraisal of the Conventional View

Economic Growth and Unemployment: A Reappraisal of the Conventional View

JOHN A. TATOM

t J~HEunemployment experience of the 1970s stands the simplicity of Okun’s Law, as well as its purported in marked contrast to the possibilities for unemploy- success in explaining and forecasting the unemployment and growth which had been envisioned by ment rate, has led to its widespread acceptance.4 most analysts and policymakers at the end of the While Okun’s Law has provided some insights for 1960s. At that time, most observers agreed that out- analysis of aggregate economic activity, unquestioned put could not continue to grow as fast, or the acceptance of the original empirical specification of unemployment rate remain as low, as in the late 1960s without an accelerating rate of inflation. the relationship has been unwarranted. Gloser examination indicates that the original specification does Nonetheless, maintaining an unemployment rate of not provide an accurate view of the link between about 4 percent and achieving a4 percent annual changes in the nation’s output •and unemployment. growth rate of the nation’s output •of goods and services appeared to be a realistic expectation.1 This relationship between output growth and unemployment can be revised to capture more accu- Except during 1973, however, the unemployment rate rately the empirical link which existed in the 1950s has been markedly higher over the past eight years and 1960s, and which continues to hold. Even the than during the prior decade. revised relationship is shown to provide only a The explanation offered for such apparently exces- rough explanation of the level of the unemployment rate, Nevertheless, variations in the rate of growth of sive unemployment is often quite simple — insuffi- cient demand for national output.2 This view of the the nation’s output are a sufficiently dominant factor unemployment-aggregate demand relationship draws that the revised rule provides a reliable tool for fore- support from an investigation of the link between casting changes in the unemployment rate. A signifi- changes in the unemployment rate and output growth cant implication of this reappraisal is that judgements in the l95Os and early 1960s.3 The underlying em- concerning economic performance and the role of pirical relationship, embodied in what has come to activist demand management policies based upon the be called “Okun’s Law,” was originally intended to level of, or changes in, the unemployment rate are provide a means of identifying the loss of national output associated with unemployment. While more de- ~This popularity is illustrated by George L. Perry’s remark that “Okun’s Law ... is probably the most robust macro- tailed methods have been developed for this purpose, economic relationship yet developed,” in “Potential Output: Recent Issnes and Present Trends,” U.S. Productive Capacity: Estimating The Utilization Gap (St. Louis: Washington t See, for example, Arthur M. Oknn, The Political Economy of University Center for the Study of American Business, 1977), p. 1; and Otto Eekstein’s remark in his comment on George Prosperity (Washington, D.G.: lirookings Institntion, 1970), especially pp. 60 and 100-02. L. Perry, “Potential Output and Productivity,” Brookings Papers on Economic Activity (1:1977), pp. 54-55, “It re- 2Two of the stronger recent statements of this view may be mains as true today as it was a decade ago that Oknn’s Law found in James Tobin, “How Dead is KeynesP” Economic is the best predictor of aggregate unemployment.” Also, the Inquiry (October 1977), pp. 459-68, and Arthur M. Okun, unemployment rate in the St. Louis Model has been deter- “The Great Stagfiation Swamp,” Challenge (November/De- mined by an Okun’s Law relationship relating the nssemploy- cember 1977), pp. 6-13. ment rate to current and one quarter lagged values of the GNP gap. See Leonali G. Andersen and Keith M. Carison, ~Arthur M. Okun, “Potential GNP: Its Measnrement and “A Monetarist Model for Economic Stabilization, this Re- Significance,” in American Statistical Association, Proceedings view (April 1970), pp. 9 and 14, and Roger W. Spencer, of the Business and Economic Statistics Section, 1962, pp. “Population, The Labor Force, and Potential Output: Impli- 98-104, and reprinted in The Political Economy of Prosperity, cations for the St. Louis Model,” this Review (February pp. 132-45. 1971), pp. 15-23.

Page 18 FEDERAL RESERVE BANK OF ST. LOUIS OCTOBER 1978

Unemployment Rate

Per,,,! Adj~d,d Perc,,,t

IC ir 10 ~IliM ~IftJ!]tft~ 1lIi~!jllft’J]!ftI~~~ I II I]

— C 9953 1954 9955 1956 1957 9958 1959 1960 1961 1962 9963 1964 1965 1966 1967 1968 1969 1970 9971 1972 1973 9974 9975 1976 1977 1978 Sh,ded ,,,~,,,pr’,’,’tp,,i’d’~~bv,denre,e,,i,,& ~ U.5 d&e pIe”d; J’d seriously biased by the acceptance of the original of the size of the gap between actual and potential specification of Okun’s Law. output.

Since Okun’s original work, measures of potential What Is Okun’s Law? output have been developed which take into account In his original article, Okun used several statistical additional factors such as the use of capital and techniques to assess the relationship between unem- energy resources which affect productivity and po- ployment and aggregate output in order to establish tential output.° Nonetheless, the use of the Okun’s a measure of the output which could be produced Law relationship as a means of explaining (or at under conditions of “full employment.” The tech- least forecasting) the unemployment rate remains niques used involved relating first differences of un- relatively widespread.~ employment to the growth rate of output, using var- Some of the difficulties with the original specifica- ious measures of the gap between potential and actual tion of Okun’s Law may he seen by an estimate of output, and using a linear logarithmic relationship be- equation (1) using quarterly data from 1/1953 tween employment and output and time. The bench- through 111/1977. Two alternative measures of po- mark assumption was that full employment and, thus, tential output are used to measure the GNP gap; the production at the economy’s “potential output” rate, first, that of the Gouncil of Economic Advisers occurred at an unemployment rate of 4 percent. The (GEA), and the second based upon updated quar- study concluded that each percentage point of unem- terly estimates by Rasche and Tatom,8 ployment above 4 percent of the labor force implied a 3 percent “gap” of lost output.5 This relationship 6 can be summarized as: See the discussion of the literature on potential output measures in Robert H. Rasche and John A. Tatom, “Energy Re- sources and Potential GNP,” this Review (June 1977), pp. (1) U = 4.0 + 1/3 GAP 10-24, especially pp. 10-13. ~Aceordingto equation (1), changes in the unemployment where Uisthe overall unemployment rate and GAP rate depend upon changes in the gap, which in turn depends is the percentage excess of potential over actual out- on the difference between the rate of change in potential put. When the economy’s unemployment rate differs output (economic growth) and the rate of change in actual output. Since the unemployment rate is equally responsive from 4 percent, the equation allows a calculation to a decrease in the rate of economic growth or an increase in the rate of change of actual output, the response of the unemployment rate to either is discussed here using the terms 5 economic growth and the rate of change of actual output Okun, “Potential GNP,” p. 100, points out that the 3toI interchangeably. link between output growth and the unemployment rate is 8 approximate, His “own subjectively weighted average of the See Peter K. Clark, “A New Estimate of Potential Output,” relevant coefficients” implies a gap coefficient in the equation U.S. Congress, Joint Economic Committee, Hearings on the equal to 0.3125, slightly lower that the one-third figure used Economic Report of the President, 95th Cong., 1st sess., Janu- here. ary 19, 1977, pp. 39-54; and Robert H. Rasche and John A.

Page 17 FEDERAL RESERVE BANK OF ST. LOUIS OCTOBER 1978

(2) U = 4.58 + .325 CAP (CEA measure) (20.57)( 12.55) Table I = .96 SE. = .279 D.W. = 1.32 ~ = .87 An Estmate of the Full-Employment (3) U = 4.99 + .359 CAP (Rasche-Tatommeasure) Unemployment Rate (1l.56)( 14.35) Year .!~!! Year Rate RO==,97 S.E,=,250 D.W.= 1.32 ~=,94 Both equations indicate constants which are sig- 1950 4.0 1964 4.4 nificantly above the 4 percent level used in the 1951 3.9 1965 4.4 original law (t-statistics are shown in parentheses). 1952 3.7 1966 4.4 Moreover, both equations indicate significant serial 1953 3.6 1967 4.4 1954 3.8 1968 4.5 correlation of the errors, even though allowance is made for a first-order autoregressive scheme. Also, 1955 4.0 1969 4.5 when the rho-statistic is close to unity, the appropriate 1956 4.0 1970 4.5 statistical procedure is estimation of the coefficients 1957 4.0 197! 4.6 using a first-difference form, which in this case would 1958 4.0 1972 4.8 mean that changes in the unemployment rate are re- 1959 4.? 1973 4.8 lated to changes in the GNP gap.9 1960 4.1 1974 4.8 196! 4.1 1975 4.8 The only change in the original statement of the 1962 4.2 1976 4.9 relationship which has become widely agreed upon 1963 4.3 is that the unemployment rate at full employment S cc Ue,.,,’t I. Fvrr,. ,..tenflul th.t;.:.t mci 1’’,.!urti’ can no longer be regarded as constant at 4 per- 13.c”., i,.Fe I’ap, i.e itr.,,,,,,,nr i.c.r,t ,,,i:1U 1. i LIt. cent. Since different groups of individuals have large differences in their unemployment experience, even for t’xaIolpli”. ‘l’ulilc’ I sllo\vs liii’ ariiiinol fitll—eniplov— under high,employment conditions, changes in the 1111111 lIIc’fl1~lI)\iiIi’iit rate receuflv cuiistriic.’trd by composition of the labor force can have substantial Pc’rrv.’ lie niraslires eori~tntctecI In the Council of effects on the aggregate unemployment rate. Recent Lcoiionoic ~d\ iser’ are 9 niLe siuli far. ‘‘lie estirnatec studies of potential output allow for changes in the indicate that tine cnn i’tannt iii the ()kuntc I nw ii[uttiinli “full-employment unemployment rate” due to changes has risen twin -I pritvnnt in’ 195.5 to about 5 percent in 1 in the age and sex composition of the labor force. ° the 1970s. The most notcwc.iitl iv effect of account— Such measures attempt to capture the different un- n~ lot the c_lianWe in, the iiiii’nilpIo>ifleiit benchmark employment and participation experience of different al 1 i iidicute~ the I S econlolli’ ‘‘U’ ‘‘peratiniL! groups within the labor force. These studies imply at lull c’nnp!o> nmn,1 in 1973 .~dearls 1971. csntrarv the use of a variable intercept, U~,in equation (1), to I lie ilnuniniant \ en at that time w.lueh dunned that instead of the constant of 4 percent. The relation- tilt’ ((inllO!lIV bath nxcess ctpaeit\ ship may then be expressed as U°= b GAP, where U* is the excess of the unemployment rate, U, over Okun’s original estimate of this responsiveness. When the first-difference test used below is applied to his data, esti- the full-employment level, U5, and bisthe respon- mates of b are found which are consistent with the larger siveness of the unemployment rate to growth, as responsiveness indicated in this article. A fuller discussion 11 of these results is available from the author in the unpub- measured by changes in the gap. lished memorandum, “An Alternative Estimate of Okim’s Law.” 12 Tatom, “Potential Output and Its Growth Rate — The Domi- 5ee Perry, “Potential Output and Productivity,” Table 6, nance of Higher Energy Costs in the 1970’s, in U.S. Produc- p. 28, Others have suggested increases in the full-employ- tive Capacity: Estimating the Utilization Cap, pp. 67-106. The ment unemployment rate above those estimated by Perry and minor changes in the latter series reflect data revisions by the the CEA. For example, Michael L. Wachter estimates the Bureau of Labor Statistics and an extension through the third recent rate is about one-half of one percent above Perry’s quarter of 1977. The series used have been subsequently estimate. See his comments following Perry, “Potential Out- modified, but the conclusions are not appreciably affected by put and Productivity,” p. 51. Also see Martin Feldstein, “The the modifications. Economics of the New Unemployment,” The Public Interest 9 (FaIl 1973), pp. 3-42, and ‘Unemployment Compensation: See, for example, Jan Kmenta, Elements of Econometrics Adverse Incentives and Distributional Anomalies,’ National (New York: The Macmillan Company, 1971), pp. 289-92. Tax Journal (June 1974), pp. 231-44. Feldstein argues that lO5ee George L. Perry, “Labor Force Structure, Potential Out- a more generous unemployment compensation system in the put, and Productivity,” Brookings Papers on Economic Ac- seventies has affected the opportunity cost of accepting tivity (3:1971), pp. 533-65: Perry, “Potential Output and employment offers. Such an argument suggests further in- Productivity;” Clark, “A New Estimate of Potential CNP;” creases in the benchmark unemployment rate, over and and Rasche and Tatom, “Energy Resources and Potential above the increases indicated by demographic factors which GNP,” and “Potential Output and Its Growth Rate,” are estimated by Perry and the CEA and used below, 11 t3 Perry, “Labor Force Structure,” estimates such an equation See “The Debate Over Gauging the GNP Cap,” Business using armnal data and finds an estimate of b consistent with Week, June 9, 1973, pp. 76-77.

Page 18 OCTOBER 1978 FgDERAL RESERVE BANK OF ST. LOUIS that a first-difference form of the equation is appro- I’:Lble’ 11 priate, and that each equation may suffer from the omission of other significant explanatory variables. ‘Fwo Estimates of Okntnis 1 ,inv I!195:3~1V/I969~ First-difference equations are shown in the lower por- tion of Table TI. Note that in the second equation, autoregression is a problem, even in the first-difference Levels form, which has been removed using the Cochrane- C cF:A Output Gap: Orcutt technique. The first difference equation estimates provide strong support for the size of the U0..21.2SCt I .ZIIOG: ~1.86) (8.14) response of the level of unemployment found in the 2 level equations. R . .97 D.W. 1.65 X~= .4568 SE = .196 = .85 (17.19) The equations indicate that unemployment is more C Rasche-Tatom Output Gap: sensitive to the rate of change of output than the

L° .27.55G. 4~.1791 G,.i original Okun’s Law suggestsY~Conversely, this means (9.75) (6.21) that the change in the output gap associated with a

-. 13W. 1.iO ~(3, =1575 given change in the unemployment rate is smaUer than SE.. lot; On (16.09) implied by the original specification. The sum of the coefficients on the current and lagged values of the gap First Differences termns indicates a gap coefficient close to 0.45. The sum coefficient indicates that a 2.22 percent (1/0.45) out- C CEA Output Gap: 0 put loss is associated with each one percent of unem- AU . .2172 AC ±.2358 AG -t ployment in excess of the full.emplOYment level. (7.79) (8.44) 1 2 R .79 OW. 1.74 Xft .4531 This change has important implications for the con- SE. ~.: 2113 (15.56) duct of monetary and fiscal policy. If unemployment is more sensitive to growth than the original formula in- C Ra~the—tat~mOuttnnlt Gap: 6 dicates, the GNP gap associated with any observed M .2870 AG, + .671 AC-: (10.34) (5.99) level of unemployment would be smaller. Thus, the 2 increase in output required at any time to achieve B 83 11W. 2.00 ~. .4512 SE. .190 ~ .27 03w) full employment is smaller than the original relationship indicates. Also, high~emplOYment budget esti- ut ± cc. ~huwn Lu ~oncinlic cs, mates which are based on overly optimistic assess-

Another Look at Okun’s Law These statistics partly jndicate the misspecification intro- duced by omitting a significant lagged value of the gap. Estimates of equations of the form U* = b CAP In spite of the specification errors, it is useful to consider

for the period prior to the l970s, 1/1953 - 1V/1969, the size of the forecast errors using the equation. On average, the unemployment forecast is 0.74 percentage points are shown in Table II. The full~emplOymcnt unem- above the actual rate during 1974, and 0.75 percentage ployment rate series used in each case is that pre- points below the actual rate observed from the second quarter of 1975 through the beginning of 1977. pared by the CEA.14 A lagged value of the gap is significant in each case, and there is significant positive leA look back at one of Okun’s methods of estimating this responsiveness reveals the difference in results. When Okun autoregression in both of the equations.’~Again, the estimated the relationship between quarterly changes in the rho-statistic is sufficiently close to unity to indicate employment rate and actual output growth, he omitted a0~significant lagged output growth term which, if it had been included, would have yielded the results above. For l4When constants are included in the equations in Table II example, when changes in the unemployment rate for the they are not statistically significant and have no effect or, civilian labor force age fourteen and over are used with the gap coefficients (to t’vo decimal places). This result real CNP growth for the period Ill/1947-IV/1960 Okun’s indicates that the ful1~empIoyment ~~empioyment rate series first test, the constant is 0.30 and the output growth coefficient is —0.31, essentially Okun’s results (—0.30) for the used adequately captures the actual changes in the rate. period beginning in H/1947. When output srowth in the Additional lagged gap terms are also not significant. prior quarter is added to the equation, its coelhcient (—0.21) lCSteplsen K. McNees, “The Current Business Cycle in Histori- is significant (t —5.78). When added to the current quarter cal Perspective,” Federal Reserve Bank of Boston New growth coefficient (--0.23), the sum (—0.44) is approxi- England Economic lteciew (Jannary/Februatl 1978), pp. mately the size of the gap coefficient found above2 The 44-59, uses the CEA data to estimate an Okun’s Law equa- constant in such an equation is 0.42, while the F is 0.70, tion and concludes that it “explains” u,lcmnnloyment from D.W. - 1.80, SE. 0.31. The standard error is markedly 1973 through 1977 quite well. The equation he uses contains lower than when only current output growth is included only the current gap. A replication of his equation yielded (0.40). a rho value of 0.88 and Durbin-WatsOn statistic of 1.40. Page 19 FEDERAL RESERVE BANK OF ST. LOUIS OCTOBER 1978 ments of this output gain provide a mistaken impression of the possibilities for new spending ini- Fable Ill tiatives and tax cuts or understate high-employment Two Estim lies of Okun\ I_ass’ Federal borrowing requirements. Finally, attempts to I./l953~lIl/1977* change the unemployment rate through policies which temporarily stimulate or slow output growth Levels would yield larger unemployment rate changes than anticipated. Such policy errors would promote greater C C’l’A Output (;ap 96 cyclical variability of the economy’s output. -. .2220G, ~- .l OG:~a (br) (9.41)

-- .98 DW. = 1.16 ~. 4mfl The Unemployment Rate in the 1970s SE. ‘‘.200 ~ .85 ‘2170)

Dynamic simulations of the unemployment rate C. Ra~che’Tatoin Onipu I sap: level equations in Table II do not forecast the unem- U .2770 C .1821 Gi_, ployment rate in the 1970s well using the respective (13.19) (8.72) 7 GNP gap estimates.’ On the other hand, the evidence D.W. - 1.10 ~, ::r459.j in Table II indicates that neither equation should be SE. =‘ .187 ~.- .95 ~2l.33) expected to perform well, since the statistical proper- ties of the equations show the appropriate statistical rirst DAte rc-nees relationship is the first-difference form. That is, an equation of the form proposed by Okun (augmented - GEA Output Gap: for a lagged response) can give reasonable predic- AU° -. .2413 AG, — .1&26 AG: i (11.68) ~8.84) tions of changes in the unemployment rate, but it does not predict the actual level of the unemploy- .80 D.\\’. :‘ 1.94 ~, =12:39 ment rate very well. The role of the adjustment for S.F 02 - ‘ .24 (lOIS’ autoregression in obtaining the excellent fit of the Ba~rhe—3ut’,,n Output Gap: level equations during the sample period is very M’° .2871 AG . .167-I AG large. Other factors may be of too great importance (14.33) ~.37) to allow one to forecast unemployment levels well fl:! .5~ OW. 203 ~3. ‘ .1548 using only information on output gaps. S.F. .181 r-:30 C 18.01

6 Simulations of the first-diflerence equations fore- 1 ,n’I .—tjr~ ‘, .hc .‘n ‘, ‘‘n,’.’: cast much better.~~For the forecast period 1/1970- 111/1977, the average error in predictions of changes in the excess unemployment rate is 0.011 and the tion in Table II. The comparable errors using the root-mean-squared error is 0.23, using the CEA equa- Rasche-Tatom equation are 0.08 and 0.18, respectively. While the average error in each reflects the inability 7 ~ The appropriate test of the forecasting ability of the equa- of the first-difference equations, on average, to ex- tions are dynamic simulations which omit information on the plain fully the higher levels of the unemployment past forecast errors during the out-of-sample period. Static simulations take into account the lagged error term in the rate since the end of the l960s, the size of the average equations, The mean error and root-mean-squared error for error is not significantly different from zero. The root- the CEA level equation for the period 1/1970-111/1977 are —0.22 percent and 0.50 percent, respectively. The mean error mean-squared error of the first-difference equation of the dynamic simulation of the Rasche-Tatom equation of forecasts are only slightly different from the standard 0.46 percent indicates underprediction and the root-mean- squared error is 0.62 percent. Static simulations of the level error in the sample period. equations forecast better for the same period, yielding mean errors and root-mean-squared errors of —0.04 and 0.23 per- When the equations in Table II are reeslimated cent, respectively, for the CEA equation and 0.06 and 0.17 percent, respectively, for the Rashe-Tatom equation, Thus, through the third quarter of 1977, there are only static forecasts using either equation may provide fairly slight changes in the equations. These equations are accurate one quarter ahead forecasts while not “explaining’ unemployment very well. shown in Table III. The fit of the Rasche-Tatom 15 Since the estimate of the first-difference equation using the equations is slightly better over the longer period, Rasche-Tatom gap measures includes the lagged error term ‘svhile that of the CEA equations is slightly worse. to eliminate autocorrelation, the simnlation reported is again a dynamic one, The simulation of the equation which Again there is agreement between the gap coeffi- uses the CEA gap measure is a static simulation since the cients in both the level and first-difference equations. estimated equation is an ordinary least squares (OLS) estimate, The sum of the coefficients in the Rasche-Tatom

Page 20 FEDERAL RESERVE BANK OF ST. LOUIS OCTOBER 1975 equations is about the same as in the earlier period growth of potential output was discussed by the CEA while the sum in the CEA equations falls to 0.42. The in 1977.21 Chow test indicates the absence of structural change 1 The same assumptions about the growth of output in the post-1969 period in all cases hut one. ° Thus, (4.75 percent) and potential output (3.5 percent) the quality of the level forecasts from the simulations give a much larger reduction in the unemployment of the equations estimated over the 1950s and 1960s rate over the next five years, however, when the re- does not appear to arise from a change in the struc- vised rule is used. The reduction of the unemploy- ture of the empirical relationship. ment rate to the full-employment benchmark used Okun’s Law, even when revised, provides only a here, 4.9 percent, would occur in the second quarter very rough explanation of the unemployment rate in of 1980 rather than at the end of 1981, as in the the 1970s. While the evidence shows that changes in budget projection. Moreover, the assumption of a 3.5 the gap, due to differential growth rates in potential percent rate of growth of potential output is prob- and actual output, have a significant impact on ably optimistic and thus understates the rate of re- changes in the unemployment rate from quarter-to- duction of the GNP gap. This means that the unem- quarter, and that this relationship does appear to ployment rate would fall faster than the Administra- have remained stable in the 1970s, it also indicates tion estimate. The average annual growth rate of that the relationship between the GNP gap and the potential output from the recession trough through level of the unemployment rate is not sufficient to the third quarter of last year is only 3.0 percent in the Rasche-Tatom estimate, as opposed to the 3.5 explain satisfactorily the high levels of unemploy- 22 ment since 1969. percent projection in the CEA data. If continued, the excess of actual over potential growth would be 1.75 percent per year with the Administration’s fore- Prospects for the Unemployment Rate cast of CNP growth, resulting in an annual reduction of about 0.8 percentage points in the unemploy- Using a device like Okun’s Law, the prospects for ment rate (0.45 >( 1.75 = 0.7875), about twice unemployment rate developments may be readily the rate of decline estimated by the Administration.2’ stated. According to the revised “law,” the unem- Should such actual and potential output growth be ployment rate declines roughly 0.45 percentage realized from the second quarter of 1978 on, the full- points per year for each one percent excess of real employment unemployment rate benchmark used here GNP growth over the rate of growth of potentia] of 4.9 percent would be achieved in the third quarter output. of 1979 rather than at the end of 1981, as projected in For example, the Administration recently forecast the budget. Viewed in tenns of timing, recent budget a rate of real GNP growth for 1978-79 of 4.75 per- policy proposals aimed at achieving an unemployment cent and projected a continuation of this growth target by a certain date in the future appear to be 2 much more stimulative than the proposed budget through 1983 to achieve their goals. ° The accom- 24 panying path of the unemployment rate indicates a indicates. decline of 0.4 percentage points per year, with the rate reaching 4.9 percent at the end of 1981 and 4.0 “See Council of Economic Advisers, Economic Re-port of the President, 1977, pp. 55-56. percent in IV/1983. While it is not explicitly stated, “See Rasche and Tatom, “Potential Output and Its Growth the estimated reductions appear to be based upon an Rate,” pp. 84, 100-102. assumed rate of growth of potential output of 3.5 “The contrast may also be seen with reference to data from percent per year together with the old “three to one” the recent past. The onemploymeut rate in the first quarter of 1978 ~vas 6.2 percent, 2.7 percentage points lower than link between growth and unemployment given by the unemployment rate peak in the second quarter of 1975. the original form of Okun’s relationship. Such a rate of Over this period, real GNP growth averaged 5.0 percent per year. The post recession potential output growth rate of 3.0 percent annually, together with the 0.45 rule, indicates a ‘°The first-difference equation using the CEA output gap decline of 2.5 percent over these eleven quarters, only measures has a significant autoregressive disturbance term slightly below the reduction in excessive unemployment in the longer period which is not significant in the earlier actually observed. Using the one-third estimate of the re- period. A Chow test of structural change using both the sponsiveness and 3.5 percent annual potential growth implies ordinary least squares and generalized least squares esti- a reduction of only 1.4 percentage points, much smaller than mates of the eq~iation indicates structural change at the the reduction which actually occurred. one percent significance level in the generalized least squares 4 estimate. ‘ See Keith M. Carlson, “Economic Goals for 1981: A Monetary 20 Analysis, this Review (November 1977), pm 2-7, for an See 15.8. Management and Budget Office. The Budget of the analysis of an earlier Administration plan. He points out United States Government: Fiscal Year 1979, pp. 29-33. the imphcatioris of policies to achieve such rapid real GNP

Page 21 FEDERAL RESERVE BANK OF ST. LOUIS OCTOBER 1978

Summary and Conclusion When the revised pieces of Okun’s Law are re- assembled, a serious statistical problem remains. The Okun’s Law — a relationship between the unem- coefficient of a lagged error term required to elimi- ployment rate and the level of the GNP gap — was nate autoregression in the level equations is near not originally intended to explain the unemployment rate, but instead, to provide a means for measuring unity and plays a major role in the high quality of the statistical results. Forecasts based upon the level potential output In recent years, alternative methods equations tend to be of significantly lower quality have been developed to measure potential output beyond a sample period since this disturbance term which have a stronger basis in economic theory and statistical method. Nonetheless, use of the relation- cannot be taken into account. ship as an explanation of the unemployment rate has Nonetheless, the first-difference equations and the continued. simulation experiment indicate strong support for the An examination of Okun’s original formulation as larger responsiveness found in the level equations and, more importantly, show that quarterly changes an explanation of unemployment shows that it is not very satisfactory. Besides recent evidence showing in the level of the unemployment rate are dominated that the full-employment unemployment rate has by economic growth. Thus, the rule of thumb de- risen since the original work, the evidence presented veloped here may be a useful tool for forecasting. This here points to a larger responsiveness of the unem- rule, however, indicates that the unemployment rate ployment rate to real output growth. is more sensitive to economic growth than most observers may have believed and suggests the use growth for accelerating inflation and negligible real Federal of increased caution in attempts to guide the economy spending growth. by activist demand policies.

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