Question

Assume an economy that has a natural rate of unemployment of 6% and an Okun’s Law curve with a slope of − 1/2 .

(a) Suppose short-run output over the next 4 years is +1%, 0%, -1%, and -2%. According to Okun’s Law, what unemployment rates would we expect to see in this economy? (b) Consider the same economy in which the unemployment rate over the next 3 years is 6%, 7%, and then 4%. According to Okun’s Law, what are the levels of short-run output Y˜ in this economy?

Answer 1

Okun's law will have the following rule

unemployment gap = -1/2 x short run output gap

a) First year unemployment rate => (u - 6%) = -0.5*1 or u = 5.5%.

Second year unemployment rate => (u - 6%) = -0.5*0 or u = 6%.

Third year unemployment rate => (u - 6%) = -0.5*-1 or u = 6.5%.

Fourth year unemployment rate => (u - 6%) = -0.5*-2 or u = 7%.

b) Modify the Okun's law to get short run output gap = -2 x unemployment gap

First year short-run output = -2 x (6% - 6%) = 0

Second year short-run output Y = -2 x (7% - 6%) = -2%

Third year short-run output Y = -2 x (4% - 6%) = +4%