OKUN’S LAW: CAN IT STILL BE A BEST RULE OF THUMB? (A TIME-SERIES ANALYSIS) A Thesis Presented to the Faculty of California State Polytechnic University, Pomona In Partial Fulfillment Of the Requirements for the Degree Master of Science In Economics By Abdullah Alkraidees & Anees Ayaz 2014 SIGNATURE PAGE THESIS: OKUN’S LAW: CAN IT STILL BE A BEST RULE OF THUMB? (A TIME SERIES ANALYSIS) AUTHOR: Abdullah Alkraidees & Anees Ayaz DATE SUBMITTED: Spring 2014 Economics Department Dr. Carsten Lange _________________________________________ Thesis Committee Chair Economics Dr. Bruce Brown _________________________________________ Economics Dr. Craig Kerr _________________________________________ Economics ABSTRACT Since 1962, policy makers and economists consider Okun’s law as a pillar of mainstream economics. Keeping this point into consideration, the main goal of our research project is to find out a relationship between the unemployment rate and the GDP growth rate as proposed by Okun (1960). The paper also focuses on the short-run and long-run relationship between these two variables. For this purpose a time series data from 2001 to 2013 is used, and is divided into two time periods, on quarterly basis, 2001:Q1-2007:Q4 and 2008:Q1-2013:Q4. Time-series econometric techniques are applied on each period to find an association between unemployment rate and GDP growth rate including Augmented Dickey-Fuller (ADF) test for stationary analysis, Engle-Granger test of co- integration and Johansen test of co-integration for co-integration analysis, vector auto- regressive model (VAR), and vector auto-regressive model (VECM) for finding inter- dependencies between variables, and finally estimating a difference version of Okun’s law regression equation. The results show a long-run association between the unemployment rate and the GDP growth rate in both periods i.e. 2001:Q1-2007:Q4 and 2008:Q1-2013Q4, but no contemporaneous impact on the unemployment rate by the GDP growth rate. iii TABLE OF CONTENTS SIGNATURE PAGE ................................................................................................................ ii ABSTRACT ................................................................................................................................ iii LIST OF TABLES .................................................................................................................... vi LIST OF FIGURES ................................................................................................................. vii CHAPTER 1 ................................................................................................................................ 1 Introduction ......................................................................................................................................... 1 CHAPTER 2 ................................................................................................................................ 3 1) What is Okun’s Law? .................................................................................................................. 3 1.1) Okun’s Law? ......................................................................................................................................... 3 1.2) Okun’s assumptions.......................................................................................................................... 3 1.3) Okun’s observation ............................................................................................................................ 4 1.4) The other versions of Okun’s law ............................................................................................... 6 2) Literature Review ......................................................................................................................... 7 Chapter 3 .................................................................................................................................. 10 1) Methodology ................................................................................................................................ 11 1.1) Model Specification ......................................................................................................................... 11 1.2) Time Series Econometric Concepts ....................................................................................... 12 2) Econometric Techniques ....................................................................................................... 14 2.1) Augmented Dickey-Fuller Test (ADF) .................................................................................... 15 2.2) Vector-Autoregressive Model (VAR) ...................................................................................... 17 2.3) Tests of Co-Integration and Error-Correction Model (ECM) ....................................... 20 3) Empirical Results and Discussions ...................................................................................... 21 iv 3.1) 2001:Q1 – 2007Q4 .......................................................................................................................... 21 3.2) 2008:Q1 – 2013:Q4 ......................................................................................................................... 34 Conclusion ............................................................................................................................... 46 REFERENCES ......................................................................................................................... 49 v LIST OF TABLES Table 1 Unemployment In Levels 2001:Q1 - 2007:Q4 ...............................................22 Table 2 Unemployment Rate After First Difference 2001:Q1 - 2007:Q4 .................. 23 Table 3 GDP In Levels (2001:Q1-2007:Q4) .............................................................. 25 Table 4 GDP Growth After First Difference (2001:Q1 - 2007:Q4) ........................... 26 Table 5 Residual Unit Root Analysis (2001:Q1 - 2007:Q4) ...................................... 28 Table 6 Lag-Length Criteria (2001:Q1 - 2007:Q4) .................................................... 29 Table 7 Johansen Test of Co-Integration Test Results (2001:Q1 - 2007:Q4) ............ 30 Table 8 VECM Results (2001:Q1 – 2007:Q4) ........................................................... 32 Table 9 Wald Test Results (2001:Q1 - 2007:Q4) ....................................................... 33 Table 10 Okun's Law Regression Results (2001:Q1 - 2007:Q4) .................................. 34 Table 11 Unemployment Rate In Levels (2008:Q1 - 2013:Q4) ................................... 35 Table 12 Unemployment Rate After First Difference (2008:Q1 - 2013:Q4) ............... 36 Table 13 GDP Growth Rate In Levels (2008:Q1 - 2013:Q4) ....................................... 38 Table 14 GDP Growth Rate After First Difference (2008:Q1 - 2013:Q4) ................... 39 Table 15 Residual Unit Root Analysis (2008:Q1-2013:Q4) ........................................ 40 Table 16 Lag-Length Criteria Results 2008:Q1 – 2013:Q4......................................... 41 Table 17 Johansen Test of Co-Integration Test Results (2008:Q1 - 2013:Q4) ........... 42 Table 18 VECM Results (2008:Q1 - 2013Q4) ............................................................ 44 Table 19 Wald Test Results (2008:Q1 - 2013:Q4) ...................................................... 45 Table 20 Okun's Law Regression Results (2008:Q1–2013:Q4) .................................. 46 vi LIST OF FIGURES Figure 1 Unemployment Rate In Levels (2001:Q1 - 2007:Q4) .................................... 22 Figure 2 Unemployment Rate After First Difference (2001:Q1- 2007:Q4) ................. 24 Figure 3 GDP Growth Rate In Levels (2001:Q1 - 20017Q4) ....................................... 24 Figure 4 GDP Growth After First Difference (2001:Q1 - 2007:Q4) ............................ 27 Figure 5 Unemployment Rate In Levels (2008:Q1 - 2013:Q4) .................................... 35 Figure 6 Unemployment Rate After First Difference (2008:Q1 - 2013:Q4) ................ 37 Figure 7 GDP Growth Rate In Levels (2008:Q1 - 2013:Q4)........................................ 37 Figure 8 GDP Growth Rate After First Difference (2008:Q1 - 2013:Q13) .................. 39 vii CHAPTER 1 Introduction What are the main problems an economy could face? What are the main issues policy makers and economists do mostly care about? Those are three primary macroeconomic policy goals in general; economic growth – an increase in the capacity of an economy to produce goods and services from one period to another, the inflation rate – a general increase in a country’s price level of goods and services measured as an index, and the unemployment rate – the proportion of people who are actively seeking for jobs (Blanchard, 2011). Arthur Melvin Okun (1962) was the first economist who developed an economic model where he empirically connected the variations in the unemployment rate to the changes in the state of the economy captured by changes in the GNP by using quarterly data from 1947:II to 1960:IV (Dimitrios, 2006). This correlation between the two important economic variables is famously known as Okun’s law, and since then it has been used as a benchmark by policy makers to measure the cost of higher unemployment and vice versa. The association between changes in the output and the unemployment rate is of crucial interest during times of economic recession and recovery; therefore