Hello, and welcome to this lecture on Okun's Law and the natural rate of unemployment. In this class, we will discuss the relationship between growth and gross domestic product and changes in employment. We will then examine the natural rate of unemployment, that is the unemployment rate when the economy is considered to be at full employment. Recall that the Federal Reserve's mandate is not only stable prices, but also maximum employment. Today, we will focus on the relationship of output growth and unemployment and explore how low unemployment could increase inflation. Let's start with the relationship of unemployment and output growth. In the graph, you can see the US unemployment rate from the end of World War II to 2000. We will discuss the 2008 financial crisis and the COVID 19 recession at the end of this lecture. The shaded areas in the graph indicate recessions. You can see that unemployment increases rapidly during a recession indicated by the shaded areas and spikes around the end of a recession. For instance, from October, 1973 to May, 1975, the unemployment rate nearly doubled, increasing from 4.6% to 9%. At the same time, unemployment falls rapidly after the end of a recession. By March,1976, the unemployment rate had already dropped to 7.6%. During recessions, real gross domestic product, the total value of all goods and services produced adjusted for inflation falls. You can see in the graft that GDP fell up to 1% per quarter during 1974. Based on the unemployment and Real GDP charts, we find there is an empirical regularity. Real GDP growth and changes in the unemployment rate are negatively correlated. When we plot the changes in the unemployment rate against changes in Real GDP, we can see how closely related these two are. The average relationship is indicated by the red line. This empirical regularity was first stated by Arthur Okun, and is known as Okun's Law. Okun's Law can be summarized in a simple formula, percent changes in Real GDP is equal to a constant k minus β times changes in the unemployment rate, where k is the intercept and β is the slope of the red line. Estimates for the Us suggests that one extra percentage point of unemployment rate costs about 2% of Real GDP. That is β in Okun's law formula is about two. Why do monetary policymakers find Okun's Law so interesting? Because Okun's Law gives them some guidance how much unemployment will decline when they cut the interest rate to stimulate the economy. Once you have an estimate for how much Real GDP is going to increase after an interest rate cut, then you also know by how much unemployment is going to decline. So, why then don't policymakers implement policies that reduce the unemployment rate to zero? The answer is, that there is a natural rate of unemployment. This means that even when the economy is at full employment, some workers will still be unemployed. One reason for this natural rate of unemployment is, that it takes time to find a good job fit. This is called search or frictional unemployment. More generally, the pool of unemployed people consists of people who just joined the labor force. For instance, recent college graduates, people who quit their jobs to look for new opportunities, people who were laid off, which is typically temporary, and people who lost their job either because they were fired or because their employers ceased operations. It is easy to see that there will always be some transition time before unemployed start and find new jobs even when economic conditions are good. However, frictional unemployment is only one component of the unemployment rate, cyclical unemployment is the other. Let's look again at the time series of the unemployment rate in the US. You can see that there are large cyclical fluctuations, during recessions unemployment is way higher than during good economic times. The chart raises another question, what exactly is the natural rate of unemployment and what determines it? Estimates suggest that in the 1950s and 1960s, the natural rate of unemployment was 4%. For the period between 1970 and 1983, the natural rate was estimated to be 6%. And from 1984-2000, the estimate went down to 5.5%. The difference between these natural rate of unemployment estimates and the actual unemployment rate is cyclical unemployment. What accounts for the changes in the natural rate estimates? There are two key factors that contribute to the natural rate of unemployment. One is changes in the structure of the labor market, for instance, when a new technology makes a certain skill set obsolete. Another factor, a labor market institutions, consider unemployment benefits, higher unemployment benefits give unemployed more time to find a better fitting job. Monetary policy can only respond to cyclical unemployment. Trying to employ monetary policy to push the unemployment rate below the natural rate is ineffective as monetary policy does not affect the structure of the labor market or labor market institutions. For this reason, it is important to understand what the natural rate of unemployment is. This brings us back to the first three recessions in the new millennium. Let's start by looking at what happened to the unemployment rate in the early 2000s before the COVID-19 pandemic. After the 9/11 recession in 2001, the unemployment rate recovered only slowly. This prompted speculations that the natural rate of unemployment had increased. Similarly, after the 2008 financial crisis, the unemployment rate did not drop as sharply as in recessions in the second half of the 20th century. However, in December 2019, close to the end of the longest economic expansion in US history, the unemployment rate was 3.6%, way below prior estimates of the natural rate of unemployment. The COVID-19 pandemic ended this run, with the lockdowns, unemployment spiked to levels not seen since the Great Depression in the 1930s. However, once the economy reopened, shops did not recover as quickly. What can account for changes in the new millennium? One suggestion has been structural changes in the labor market. Certain skills have become or are becoming obsolete. Just consider what autonomous driving will mean for truck drivers. Other skills, mostly driven by the growing tech sector, have been more in demand than ever. At the same time, technology has made it easier to find a job, instead of local newspaper classifieds, you can search for jobs, country or worldwide in the Internet. But like most large scale changes, the full effects of these developments can only be observed over time, making it hard to know what the current natural rate of unemployment is. What have you learned in this lesson? First, Okun's Law is an empirical regularity that states that changes in the unemployment rate and Real GDP are negatively correlated. Second, even with an economy at full employment, some people will be unemployed due to frictions in the labor market. Third, the natural rate of unemployment is the unemployment rate at full employment.
