Answer to Question #90864 in Macroeconomics for Gurwinder Kaur

Question

3. According to the Okun’s Law, when the unemployment rate increases by 1 percentage point the GDP falls by approximately 2 percentage points. But our intuition suggests that it should be rather 1-to-1 relationship, i.e., when the unemployment rate increases by 1 percentage point the GDP should fall by approximately 1 percentage point:
For instance, you have 100 workers who sew jeans, each makes 10 pairs of pants per day; then your total production is 1,000 pairs of pants per day. If you lost one worker (a 1% decrease), the remaining 99 would together make 990 pairs of pants per day (a 1% decrease).
Explain why the decline in output (GDP) may not be proportional to reduction in the number of workers employed (increase in unemployment).

Answer 1

Okun's law is not universal. This law, that was acquired by Okun, based on empirical data on the US economy in the 1960s. Accordingly, this law reflected the economic reality of that period, the mutually dominating factors, both external and internal. That is, the Okun’s law is tied to a specific place and state of the economy, i.e. to the US economy and a specific time. In addition, Okun tried to express the relationship between the cyclical unemployment and the level of GDP. Our example does not apply to cyclical unemployment.