Okun’s law is a look at the relationship between falling output and rising unemployment. As a rough rule of thumb, in Okun’s original statement of his law, he found a 3% increase in output corresponded to a 1% decline in the rate of unemployment; a .5% increase in labor force participation; a .5% increase in hours worked per employee; and a 1 % increase in output per hours worked.

Therefore, as output falls we would expect a rise in unemployment as firms lay off workers. However, the relationship between output and unemployment can vary significantly.

For example, falling output in the Eurozone has led to a much smaller rise in unemployment than in the US.

Unemployment

Reasons why Unemployment in Eurozone has risen more slowly than US

• Greater protection for Eurozone workers. More difficult to fire workers
• Government subsidies for workers working shorter hours. This encourages people to work part time, rather than full time.
• Firms keener to retain skilled workers rather than the costs of laying off workers then rehiring them.

The UK has seen a rise in numbers working part time or shorter hours. Therefore, the decline in full time employment has been greater than the rise in official unemployment.

What this means is that the forecast rise in unemployment may be less than predicted, but, when the economy recovers, it will take much longer for unemployment to fall.

Source: Bank of England – inflation report. I assume it means there are over 200,00 workers working shorter hours. It wasn’t clear in data, but, the rise in numbers working shorter hours is clear.

Why unemployment won’t rise this time

Unemployment: Source: ONS

ILO-defined unemployment in April to June was 2.44 million (7.8%) – up by 220,000 unemployed on the quarter and 750,000 from this time last year.

The claimant count for key out-of-work benefits was 1,582,700 in July – up by 24,900 on last month, and up 709,000 on last year.

Measuring Unemployment

The recession has led to a sharp rise in Unemployment. With output expected to fall by a record 5.5% this year, it is hardly surprising unemployment has risen. In fact, we might have expected a higher rate of unemployment.

The growth in unemployment has been limited by factors such as a growth in part time worker and decline in participation rates. The outlook for workers, especially young people entering the labour market is grim.

International Comparisons of Unemployment with EU and US.

Unemployment ILO comparisons

This shows that unemployment in the US has increased faster than in the Eurozone. This partly reflects the fact US labour markets are more flexible. Therefore, it is easier to fire workers in the US. But, in the Eurozone area, firms appear more reluctant to take workers on during periods of growth.

Related

• To what extent do unemployment figures reflect the reality?
• UK Unemployment

The natural rate of unemployment measures the unemployment when the labour market is in equilibrium. It is composed of supply side unemployment such as frictional and structural unemployment.

For example, even when the economy is at full capacity / full employment, people may be unemployed because they lack the necessary skills to get a job. Also, even at full employment, there will always be some people in between jobs (frictional unemployment)

Cyclical Unemployment is unemployment due to negative economic growth, or output being below full capacity. In a recession, cyclical unemployment will rise sharply. This is because if there are less orders for goods, firms produce less and therefore there is less demand for workers.

(A recent study suggested UK unemployment would peak at 3.2 million in 2010 due to the scale of the current recession.)

Often cyclical unemployment can cause a rise in the natural rate of unemployment. If young people are out of work for a long time in a recession, it can be difficult to get back into employment because of lack of job experience and decline in motivation. This is known as the hysteresis theory. It occured after the 1981 recession – unemployment took a while to reduce.

• Dealing with unemployment

In the 1980s regional differences in unemployment were greater. To some extent regional differences in unemployment have narrowed in recent years. However, differences still exist. Some reasons include:

1. Decline of Industry. Some areas relied on certain industries to provide a large % of jobs. If these industries close down then areas suffer from a high rate of unemployment. A good example, was when coal mines closed down in certain areas. It led to high unemployment in certain areas such as South Yorkshire and South Wales.
2. Negative Multiplier Effect.  Depressed areas often struggle to attract investment. e.g. if an industry closes down then related to businesses suffer e.g. cafes, pubs which used to service the old industries.
3. Labour Immobility. One question is if unemployment in one part of the country is high, why don’t people move to areas where there are jobs? One issue is the difficulty of moving. For example it is:

• Difficult to gain housing in areas such as London (especially difficult if you have to sell and buy a house)
• Difficult with children in school, wives in part time work e.t.c
• Emotionally difficult to leave friends e.t.c.

4. Lack of skills / qualifications. Some inner city areas may have low numbers of qualified people who therefore struggle to gain employment.

5. Higher unemployment amongst ethnic minorities. Sometimes unemployment rates are higher in certain boroughs or areas of cities. These areas may have a high ratio of first or second generation immigrants. They may be more likely to be unemployed because of poor skills / language barriers/ discrimination e.t.c

• Unemployment in UK

Monetary policy effectively means changing interest rates to influence aggregate demand, economic growth and therefore demand for workers.

The UK is heading into recession and unemployment is rising. It is argued a cut in interest rates would help reduce unemployment.

• Lower interest rates reduce the cost of borrowing encouraging spending and investment.
• Lower interest rates reduce the cost of mortgage payments giving homeowners more disposable income and therefore spending increases.
• Therefore, lower interest rates should help increase consumer spending and investment. Therefore, aggregate demand will rise. If there is spare capacity in the economy, there will be an increase in economic growth and therefore firms will demand more workers. This will help reduce demand deficient unemployment.

However:

• Lower interest rates may not increase consumer spending if confidence is very low. (e.g. in a recession, people may not want to borrow to invest, even if interest rates are very low)
• Cutting interest rates will only solve demand deficient unemployment. It will not reduce supply side unemployment – the natural rate

• The role of AD in reducing unemployment
• Discuss whether demand side policies reduce unemployment

Firstly, we can make a distinction between:

• Supply side unemployment (the natural rate of unemployment). These are usually microeconomic imbalances in labour markets.
• Demand side unemployment (Unemployment caused by lack of aggregate demand in the economy). In the coming recession, we can expect demand deficient unemployment (sometimes called cyclical unemployment) to increase significantly.

Amongst Supply side unemployment Different types include:

• Frictional – when people are in between jobs.
• Structural – Unemployment due to occupational or geographical immobilities. Often occurs after structural change in the economy. E.g. closure of mines, left many miners struggling to find suitable work.
• Real Wage Unemployment. e.g. powerful trades unions bargaining for wages above the equilibrium. (this may be exacerbated by fall in aggregate demand)
• Voluntary unemployment. Some debate exists over this form of unemployment. But, arguably high benefits may encourage some to stay on benefits rather than take low paid jobs.
• Seasonal Unemployment

See also causes of Natural Rate of Unemployment to change

• Reasons for youth unemployment

Investment is a component of AD. AD+ C+I+G+A-M. I think, Investment spending takes about 15% of AD; it is not as significant as Consumer spending which is 66%.

If Investment increases, then ceteris paribus, AD will increase. However, it depends on circumstances. e.g. in present situation with falling house prices and lower consumer spendin, increased investment may be insufficient.

In the long term, higher investment may increase productive capacity and increase Aggregate supply. Therefore, you could argue, invesment enables a more sustainable increase in AD.

People often ask whether increased AD leads to an increase in Real GDP. Often the suggested answer is yes in the short term, but not in the long term.

See also:

• Causes of Economic Growth
• Discuss whether demand side policies reduce unemployment

Was the Government right to widen the budget deficit 1974-5 in order to stimulate demand, or should it have run less expansionary policies to temper the effect of rising prices?

I’m afraid I don’t have access to many statistics from the 1970s, so it is hard to make much analysis. But basically, the government faced a twin problem of rising prices (mainly cost push) and falling demand. (Stagflation) By pursuing expansionary fiscal policy, they were attempting to maintain full employment ( a noble objective). However, it led to a rise in inflation and inflation expectations. Combined with powerful trades unions in the 1970s, this led to a sharp rise in inflation (25% by 1979). Arguably these rates of inflation were costly for the economy and led to an almost inevitable recession in 1980. see: recession 1980-81

Another factor to consider is how much expansionary fiscal policy actually helped boost economic growth and keep unemployment low. From a theoretical perspective, economists will certainly disagree about this. Monetarists, argue that such a fiscal expansion does very little to boost real GDP in the long run. They will argue that it mainly causes crowding out and rising inflation expectations. Keynesians however, argue that a fiscal expansion does help stimulate an economy, suffering from a downturn.

Was there any policies the Government could have enacted to try and reduce both the rate of inflation and unemployment simultaniously?

The main approach would have to have been through supply side policies. In particular,

• Reduce power of trades unions to help reduce wage push inflation and real wage unemployment.
• Privatisation to increase efficiency of state owned industries (although this would probably have cause  a temporary rise in unemployment)
• Ending state subsidies
• Education and training to help structurally unemployed workers move to new jobs.

Many of these supply side policies were introduced in the 1980s, with mixed results

• Supply side policies in the 1980s and 1990s
• Economic importance of supply side policies

Related Posts

Solution to stagflation

UK Inflation in the 1970s and 80s – the role of the output gap. Evidence monetary policy errors contributed to inflation in the 1970s

The estimated unemployment rate in India has fallen this year from 8% to 7%. However, it is worth bearing in mind, it is notoriously difficult to measure unemployment in India because of high levels of disguised or ‘under-employment’. Underemployment occurs when people are not classed as being unemployed, but, they make very little from their job.

A particular problem for the Indian economy has been the agricultural sector which has a high % of the workforce but is struggling to create sufficient jobs. This has led to a shift in the working population from rural to urban areas; and there is a difficulty in creating sufficient jobs for this new sector of the population.

Economic Growth and Unemployment

The biggest factor in helping reduce unemployment in India is probably the strong economic growth. India has seen growth rates reach 7%; this increased output is creating new demand. However, economic growth alone cannot solve India’s unemployment problem because the growth tends to benefit some sectors of the economy much more than others. The growth has failed to deal with rural poverty.

Skills and Structural Unemployment

For a developing economy, India has a relatively skilled population. For example, a high % are fluent in English. However, there are still a significant % of the population who lack basic education and skills (especially women). Therefore, to reduce structural unemployment, it is necessary for the Government to improve the quality of education and training, especially in rural areas.

Liberalisation of Markets

The liberalisation of markets has helped economic growth, but, labour still retains inflexibility and some sectors have struggled with the greater liberalisation of markets.

If  you take the 1950s and 60s you could argue there was a trade off between unemployment and inflation.

As AD increased, it caused higher output, this lead to inflation as the economy came close to full employment. However, as output increased unemployment (demand deficient unemployment) fell.

Increase In AD causing Inflation Diagram

This Keynesian view of the AS curve suggests there can be a trade off between inflation and demand deficient unemployment.

However, this view is criticised by the Monetarist view, which argues increased AD only causes inflation and no increase in Real GDP in the Long term.

Monetarists argue LRAS is inelastic and therefore Phillips Curve looks like this:

Monetarist Phillips Curve Diagram

Another Criticism of the Phillips curve is that in the UK, we have witnessed falling unemployment and low inflation. During the 1990s and early 2000s supply side improvements enables lower unemployment and lower inflation. This suggests that it is possible to reduce unemployment without causing inflation.

However, you could argue there is still a potential trade off except the phillips curve has shifted to the left, because there is now a better trade off.

Also the fact that both have fallen doesn’t mean we can’t go back to the 1950s and 1960s.

It also depends on the role of Monetary policy. If monetary policy is done well, you can avoid some of the boom and bust economic cycles we experienced before. However, if you allow AD to increase too much there will be a trade off between inflation and unemployment

See Monetarist view of Phillips Curve

Related essays

Phillips Curve – Inflation and Unemployment in the UK

Discuss whether demand side policies reduce unemployment?