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Okun's Law Coefficient Is so Large

Why the Okun's Law Coefficient Is so Large? Okun's Law posits not a 1-to-1 relation but a 2.5-to-1 relationship between real GDP growth and the unemployment rate. That is, a one percentage-point fall in the unemployment rate is associated not with a 1 but a 2.5 percent boost in the level of production. Why is this Okun's Law coefficient so large? Why isn't it the case that a one percentage point fall in unemployment produces a one percent rise in output, or even less? One answer is that the unemployment rate, as officially measured, does not count discouraged workers. In a recession, the number of people at work falls, the number of people looking for work rises, and the number of people who are not looking for work because they doubt they could find jobs--but would be working if business conditions were better--rises. Because the conventionally-measured unemployment rate does not include these discouraged workers, more than a 1 percent rise in real GDP is needed to reduce the unemployment rate by 1 percentage point. Moreover, when business returns to normal, firms' initial response is not to hire more employees, but to ask existing employees to work longer hours. So average hours of work per week go up, and the unemployment rate falls by less than one would otherwise expect. Finally, in some industries employing more workers increases production by more than a proportional amount: product design and set-up need to be done only once, no matter how much is produced. Thus businesses which have economies of scale do not need twice as many workers to produce twice as much output.

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