Question

Assume you’re a policy maker, and you notice that the short run output Y˜ is falling significantly, but the cyclical unemployment u−u¯ is not rising or rising very little. What are the possible explanations (in the context of Okun’s Law) for such a phenomenon?

Answer 1

According to Okun's law we have

output gap = -alpha x unemployment gap

where output gap is deviation of output from its full employment and unemployment gap is the deviation of unemployment from its natural rate. Generally, alpha (factor of proportionality) is 2 suggesting that a 1% increase in unemployment from its natural rate can increase GDP gap by 2%, implying that GDP falls by 2% from its full employment level

But the value of alpha can be very high in several cases. When this happens, a 1% increase in unemployment from its natural rate would indicate that GDP falls by very high percentage from its full employment level.