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Did Okun’s law die after the Great Recession?

Business Economics volume 52, pages 216–226 (2017)Cite this article

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Abstract

This paper estimates Okun’s law, focusing on piecewise non-linearity in the form of structural breaks and threshold dynamics, and obtains regime-dependent as well as threshold-dependent changes in the unemployment rate. We employ an autoregressive distributed lag version of Okun’s law in first differences, which allows for delayed reactions of the unemployment rate to output growth. Applied to U.S. data over 1949Q1–2015Q4, the empirical analysis characterizes Okun’s law as a three-regime relationship with the first structural break coinciding with the 1973 oil price shock, and the second structural break immediately following the end of the Great Recession. We find support for threshold dynamics in each regime, which suggests that Okun’s law follows complex non-linear dynamics. Okun’s law, as a linear and constant “rule of thumb,” breaks down in each of the three regimes. In each regime, the unemployment rate responds asymmetrically to changes in output. In sum, Okun’s law died during the Great Recession. Only time will tell whether resurrection is feasible.

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Notes

  1. This empirical relationship forms a major part of every traditional macro-model, as the aggregate supply curve comes from combining Okun’s law with the Phillips curve. Moreover, this relationship also leads to important implications for macroeconomic policy. First, it documents what rate of growth of output leads to a reduction in the unemployment rate. Second, the effectiveness of disinflation policy depends on the responsiveness of the unemployment rate to output growth.

  2. For example, Ball, Leigh, and Loungani (2013) find evidence that Okun’s law is remarkably stable, with no evidence of non-linearity. Additionally, several studies, including Gordon (1984), Prachowny (1993), Weber (1995), Moosa (1997), Lee (2000), Harris and Silverstone (2001), Sögner and Stiassny (2002), Österholm (2016), support the empirical validity of the relationship, but the estimates of Okun’s coefficient vary substantially across countries and time.

  3. We implement, in accordance with the majority of the literature (Lee 2000), a structured version of Okun’s law, where output growth explains changes in unemployment.

  4. The distributed lag specification reduces the simultaneous equation bias for the total effect, as long as output growth is positively autocorrelated (Sögner and Stiassny 2002).

  5. For technical details of these steps, refer to a longer version of this paper posted online at the Social Science Research Network (see https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2826781).

  6. The data come from the FRED database at the Federal Reserve Bank of St. Louis and were downloaded in April 2016. See https://research.stlouisfed.org/fred2/.

  7. We apply, following the standard convention, a 10% trimming, so that each subsample contains at least approximately 26 observations (i.e., about seven years of data), and allow for a maximum of 5 breaks. We also incorporate heterogeneous error distributions across breaks. At the same time, since we include a lagged dependent variable as a regressor, we rule out serial correlation in the errors (see Assumption A4 in Bai and Perron 1998).

  8. To check further on the robustness of our results, we apply the Quandt–Andrew test to the residuals of the static and dynamic versions of Okun’s law. This one-break test does not assume a given break date. In both the static and dynamic versions, we find a significant break at 2009Q2.

  9. Following the suggestion of one referee, we also estimate the threshold model over the entire sample. This ignores the structural breaks. The findings indicate that the appropriate model is a two-state TAR model, the value of the threshold variable \(\Delta GDP_{t - 1}\) is 0.34. In the first state, the contemporaneous effect of output growth is −0.274, whereas in the second state is −0.172. In both states unemployment persistence is significant, but higher in the first (0.271) than in the second (0.187). The adjusted R2 is 0.700, which is practically the same as the adjusted R-squared obtained in the structural break model in Table 3. As in the structural break model, however, problems of serial correlation also exist in the threshold model estimated over the entire sample, especially at 8 and 12 lags.

  10. We need to view the findings of the post-Great Recession regime with a degree of caution. The problem concerns the relative shortness of the sample. To address this problem, we re-estimated the threshold model deleting the variable that is not significant in both states (i.e., \(\Delta GDP_{t}\)). The estimates of the threshold as well as the estimates of the threshold regression are substantially unchanged, as one would expect, and are not reported for that reason. Still, a caveat is in order.

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Acknowledgements

We thank two anonymous referees and the editor for their useful comments on prior versions.

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Authors and Affiliations

  1. Department of Economics, University of Nevada, Las Vegas, NV, 89154-6005, USA

    Giorgio Canarella & Stephen M. Miller

  2. Center for Business and Economic Research, University of Nevada, Las Vegas, NV, 89154-6002, USA

    Giorgio Canarella & Stephen M. Miller

Authors
  1. Giorgio Canarella
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  2. Stephen M. Miller
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Correspondence to Stephen M. Miller.

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Canarella, G., Miller, S.M. Did Okun’s law die after the Great Recession?. Bus Econ 52, 216–226 (2017). https://doi.org/10.1057/s11369-017-0045-1

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  • DOI: https://doi.org/10.1057/s11369-017-0045-1

Keywords

  • Okun’s law
  • Structural breaks
  • Threshold effects

JEL classification

  • C14
  • E31
  • C22

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