Question

1.    One of the most remarkable associations in macroeconomics relates GDP growth to unemployment or the so-called Okun’s Law (see p.293-294 in Burda&Wyplosz textbook). This empirical regularity describes inverse relationship between the change in unemployment and the change in GDP growth. Resulting negative coefficient has been repeatedly confirmed for different countries and different periods. Your task is to:

a)    Propose a modified version about how the GDP is related to the labour market. Specifically, make a formal/theoretical statement (similar to the textbook, so read the corresponding section) on how the employment rate is related to the output growth, write it down and then check the relationship with data (Finland).

b)    Find the employment rate time-series (for people aged 15-74) and the real GDP growth (all for Finland only) and retrieve a set of 40 most recent quarterly observations of both variables. Arrange the data and plot the relationship on a graph. What is the coefficient between the variables, so you need to add the trend-line relationship between the variables?

c)    Make a conclusion about how the model (Okun’s relationship) fits the Finnish data.

Answer 1

Okun’s law states that, ?Y/Y = 0.03 ? 2 × ?u,

The economy is originally at the long-run equilibrium. Suppose that, this year, a contractionary monetary policy decreases output by 4 percent,

1. Note that, when the economy is at the long-run equilibrium, the unemployment rate is constant across years. This implies there is no change in U. Hence ?Y/Y = 3%. This is the long run growth rate

2. Assume that Okun’s law is true, and it describes the economy in question perfectly. There is a 3% growth rate in long run. Now there is a decrease in the growth rate from last year to this year by 4% due to contractionary monetary policy and an increase by 3% due to Okun's law. The economic growth rate between last year and this year is given by ?Y/Y = -4% + 3% = -1%.

3. See that ?Y/Y = 0.03 ? 2 × ?u,

-0.01 = 0.03 - 2 × ?u,

2 × ?u = 4%

?u = 2%.

Hence the change in unemployment rate between last year and this year according to Okun’s law is 2%.