The Unassuming Economist

From VoxEU post by Guay Lim, Robert Dixon, Jan van Ours:

“One version of Okun’s law specifies a relationship between the change in the unemployment rate and output growth. This column uses US labour market flows data to investigate this relationship between 1990 and 2017. It finds that the net flows between employment and unemployment are sensitive to changes in growth but respond differently to positive and negative changes. This implies that the US Okun relationship is stable but asymmetric, the effect of a change being larger in contractionary periods than in expansionary ones.

There is a large body of research based on Okun (1962) in which researchers (like Okun himself) approach the relationship the law specifies in different ways. Most common are the ‘difference approach’ (i.e. examining the relationship between the change in the unemployment rate and output growth) and the ‘gap approach’ (i.e. examining the relationship between the deviation of the actual from the natural or equilibrium unemployment rate, on the one hand, and the gap between the level of actual and potential output on the other).

Recent research on US data has focused on the magnitude, the stability, and the asymmetry of the Okun coefficient over the economic cycle. Owyang and Sekhposyan (2012) show that during recent US recessions – including the Great Recession – unemployment appears to be more sensitive to economic growth than before. Cazes et al. (2013) also find that the Okun coefficient varies over time and appears to be larger during recessions than during expansions. Pereira (2013) concludes that there are asymmetries in the Okun relationship with a weaker relationship during periods of expansion. Valadkhani and Smyth (2015) also find asymmetries and a weakening of the Okun relationship since the early 1980s. Furthermore, Belaire-Franch and Peiro (2015) conclude that there is an asymmetry in the relationship between unemployment and the business cycle. Finally, Ball et al. (2017) find that Okun’s law is a strong, reliable and stable relationship and that a constant (not time-varying) Okun coefficient is a good approximation to reality.

In a recent paper (Lim et al. 2018), we look at the relationship between changes in the unemployment rate and output growth through the lens of US labour market flows. As far as we know, no one has utilised flows data in this context, yet clearly the change in the unemployment rate reflects the balance of flows into and out of unemployment within a period. Therefore it is natural to look at the Okun relationship as one between output growth and labour market flows. Our analysis is based on the ‘difference approach’ to Okun’s law, since labour market flows are informative about the change in the unemployment rate. We also propose focusing on net flows (the balance of the gross flows between any two states) as they more effectively highlight the dynamics (including asymmetries) behind the evolution of the Okun coefficient.

The flows framework provides an encompassing structure to study the relationship between GDP growth and changes in the unemployment rate and in particular, the conditions under which the Okun coefficient (i.e. the coefficient linking the change in the unemployment rate to the output growth rate) is time-varying and/or asymmetric, i.e. the change in the unemployment rate differs for positive/negative shocks to growth. Furthermore, the flows approach allows us to adopt a three-state analysis – namely, flows between employment, unemployment and not in the labour force. Thus we study how shocks to growth affects labour flows and how they, in turn, translate into changes in three summary statistics – the unemployment rate, the participation rate and the employment–population ratio.”