Figure 3.2 Output Gap Okun's law (see curiosity 3.3) measures the output gap. Negative numbers mark a loss of actual output relative to potential output; positive numbers mark periods of boom when the economy produced more than its "full employment" output. Notice the pronounced cyclical behavior of the economy. Source: Economic Report of the President, 1999. www.access.gpo.gov/eop/
Curiosity 3.3: What Is Okun's Law?
A rule of thumb, called Okun's law, is used to translate unemployment greater than the natural rate into an output gap and thereby to measure the cost to society of excessive unemployment An extra percentage point of unemployment, above the natural rate, corresponds to an output gap of about 2 percentage points of potential GDP. This rule implies, for example, that if the NRU is 6 percent, an unemployment rate of 8 percent gives rise to an output gap of 4 percent of potential GDP, or about 300 billion dollars!
It may seem odd that an extra 1 percent of unemployment is associates with more than a 1 percent change in GDP. This result occurs because firms find it more profitable to meet demand fluctuations by varying the workload of current workers rather than by varying the number of employees. Firms have a tendency to hoard labor as the economy moves into a recession, electing not to lay off as many workers as the drop in their sales would dictate. They make this choice because they do not want to risk losing workers whose skills and experience make them particularly valuable to their firm when the recession ends, and this policy allows firms to avoid the costs of hiring and training new workers. Consequently, output falls by more than unemployment rises when the economy moves into a recession, and during a recovery output can increase by making fuller use of the hoarded labor. Furthermore, when hoarded labor no longer exists, firms meet many fluctuations in demand by varying overtime, rather than by varying the number of employees. This response also reflects rational behavior on the part of the firm, since existing employees are more productive than new employees, hiring and training costs can be avoided, fringe benefit costs are unaffected, and layoff costs are not incurred.
