A Historical Evaluation of Okun's Law with State Level Extensions
Arthur Okun’s seminal 1962 paper observes a reliable and negative relationship between output and unemployment for the US Economy from 1947 to 1962. Okun’s Law posits that every 1% change in unemployment produces a 3.3% change in output. The simplicity of Okun’s Law accounts for its appeal to policymakers, providing a simple rule of thumb to measure initiatives and risks.
Okun’s US observations occurred during a time of general economic stability, absent large recessionary periods. The US Economy became more open and variable in the late 1960s and 1970s; Okun’s coefficients became unstable. Researchers now estimate a weaker relationship, applying various functional forms to better describe a new economy; some also reverse variable dependency, using a supply side model positing output as a function of unemployment. Abel, Bernanke and Croushore (ABC) quantify output as a function of unemployment using updated Okun coefficients. This paper enhances the ABC specification by adding an indicator variable for recession years, producing coefficients in agreement with Okun’s a priori theoretical expectations.
Policy makers often apply Okun’s Law at the State level, with little a priori justification. The economic makeup of individual states varies considerably requiring individual estimation of Okun models. Empirical work here applies the enhanced ABC model at the State level, with results showing significant instability in cross section analysis. Further research suggestions include regrouping states for analysis based on common demographics, industry types and similar variables.