Question

In 2008, the unemployment rate (u) was ten percent, and the natural rate of unemployment (nru) was six percent.

1. 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 in 2008 the opposite of the sign of the current GDP gap? Explain.

Answer 1

i)

According to the Okun law, the one percent change in employment rate is associated with a two percent change in the output level.

Hence, there is a 4 % rise in unemployment and it might have caused the 8 % fall in the output.

the output gap is equal to 8 %.

ii)

Here the economy is operating below the full potential level, which is 8 % below. Hence, there is the unemployment rate.

iii)

The economy is operating below full employment, thus it is called a positive gap. A positive gap indicates a recession.

iv)

The sign of GDP was opposite during 2008 due to the rise in the unemployment or economy was operating below full employment.

While presently, the economy is operating above full employment, thus gap is negative.