Okun's Law

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Definition

The math formula for okun's Law is:

In other words, when unemployment rate goes up by 1%, GDP goes down by 2%.

Practice Questions

Question #1

Q According to Okun's law, when cyclical unemployment changes from -3% to -2%, the output gap changes from _____, measured relative to potential output.

A. -6% to -4%

B. -3% to -2%

C. -1% to 0%

D. 3% to 2%

E. 6% to 4%


A Okun's law tells us that when unemployment goes up by 1%, GDP drops by 2%. Now in the question, unemployment goes from -3 to -2, meaning there's unemployment goes up by 1%, so GDP drops by 2%, and the output gap will go up by 2%... the only answer is from -6 to -4.


Question #2

Q According to Okun's law, when cyclical unemployment increases from 2 to 4%, the output gap increases from ___ %.

A. -4 to -8

B. -2 to -4

C. 0 to 2

D. 2 to 4

E. 4 to 8


A Its positive number for its changes. Unemployment up from 2 to 4, then GDP goes down by 4% (because of the times 2), and the output gap would go UP (opposite to GDP) by 4%. That means "4 to 8" is the answer.


Question #3

Q When the economy is experiencing an expansionary gap, the cyclical rate of unemployment is negative. why is it negative?


A At potential GDP, unemployment rate = natural rate of unemployment (or, think of calling the unemployment rate at potential GDP "natural rate of unemployment"). Potential GDP is describing GDP, and natural rate of unemployment is describing unemployment rate. In economics these two things happen together. Now to the question, when we have expansionary gap, that means actual GDP > potential GDP. A large actual GDP means that we're producing too much. In order to do so, we need to hire a lot of people, and that makes the cyclical rate of unemployment negative. Cyclical rate of unemployment negative means that unemployment rate is below "natural rate of unemployment".


Question #4

Q If the natural rate of unemployment is 4%, what is the actual rate of unemployment if output is 2% below potential?


A Okun's law tells us that when unemployment rate is 1% above potential, then GDP is 2% below potential. In the question, GDP is 2% below, that means unemployment is 1% above the natural rate of unemployment. So that gives us the actual rate = 5%.


Question #5

Q According to the Department of Finance estimate, in 1994, Canada's output gap was 5.5% of potential output. In the same year, the unemployment rate was 10.3%. Okun's law implies that, in 1994, Canada's natural rate of unemployment was?"


A Output gap was 5.5% means that actual GDP is 5.5% below its potential. Then unemployment rate would be 5.5/2 % above the natural rate of unemployment. That is, the natural unemployment=10.3%-(5.5/2)%