Question

The US unemployment rate (actual unemployment, u) is 8.4 percent, while the natural rate of unemployment (nru) is 4.4 percent.

(i) Using Okun's Law, compute the US current percentage GDP gap. Show your computation. (ii) State your answer in words, comparing actual to potential output. (iii) Is the US GDP gap positive or negative—and why?

Note: "Okun’s Law Arthur Okun was the first macroeconomist to quantify the inverse relationship between the actual unemployment rate and the GDP gap. He noticed that, on average:
GDP gap = −2.0 × (actual unemployment rate − natural unemployment rate)"

The note is from one of my textbooks, is the formula provided above, Okun's Law formula?

Answer 1

(i)

Okuns law basically tries to explain how the GDP changes when there is a change in the unemployment percentage.

According to Okuns law, a 1% increase in unemployment leads to a rough 2% decrease in the GDP. It is represented y the equation

GDP gap = −2.0 × (actual unemployment rate − natural unemployment rate)

In this question

Actual unemployment rate = 8.4%

Natural unemployemnt rate = 4.4%

Therefore, GDP gap = - 2 x ( 8.4 - 4.4 )

Current GDP gap = - 8 %

(ii)

The difference in output at - 8.4% actual unemployment rate and 4.4% natural unemployment rate is 8%. It means that if the potential output of the economy was Y, the current output is expected to be only 0.92Y. ( which is 8% lesser than the potential output)

(iii)

The GDP gap is negative. It implies that the current output is lesser than the potential output. The reason behind this is the increased rate of unemployment. Since the actual rate of unemployment is higher than the natural rate of unemployment, it means that a greater number of possibly productive people are not employed, thereby leading to a lower output than the economy is capable of.