Question

If unemployment increases what happens to GDP? 

Answer 1

The relationship between unemployment and GDP is given by Okun’s law. It states that for every 1% increase in unemployment rate from the natural rate, the real GDP will be 2% lower than the potential GDP. So if the natural rate of unemployment is 4% and the unemployment rate increases from 4% to 6%, the real GDP will be lower by 2% * 2 = 4% from the potential level of GDP. Therefore, we can derive that higher the unemployment, the lower will be the GDP from the potential level of GDP.

We can think of this in an intuitive way as well. Unemployment can increase because of a number of factors such as lower demand by firms or rising costs. In both the ways, firms reduce their output level, which results in a fall in the GDP. This creates a vicious cycle because more unemployment means more people earning less income or being without any income. So, the aggregate demand even falls further, which forces firms to cut output even more and hire even less workers. This cycle can continue without sufficient intervention in the economy to stimulate aggregate demand. So, in general we can say that there is an inverse relationship between unemployment in GDP, wherein higher unemployment means lower GDP.