Question

A year ago, the unemployment rate (u) was 3.6 percent, and the natural rate of unemployment (nru) was 4.6 percent.

(1 point)

(i) Again using Okun's Law, what was the percentage GDP gap then? Show your computation.

(ii) State your answer in words, comparing actual to potential output.

(iii) What is the sign of the GDP gap then?

(iv) Why is the sign of the GDP gap a year ago the opposite of the sign of the current GDP gap? Explain.

Answer 1

i) The GDP gap is the difference between actual GDP and potential GDP. Okun's law suggests a GDP gap of -2% for every 1% that the unemployment rate exceeds its natural rate. In this case, the GDP gap is (3.6 - 4.6) (-2) = 2%

iii) the sign of the GDP gap is positive

iv) an year ago the unemployment rate was lower than the natural unemployment rate, which is why the sign of GDP gap was positive. A positive output gap suggests that actual output is more than full-capacity output.