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 unemploy- ment 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 exam- ination 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 un- employment 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 out- put 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 meas- ures 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.