Okun's Law and the Fulfillment of Wage and Price Expectations
Format of Original
Taylor & Francis
Journal of Post Keynesian Economics
A well-known relationship in macroeconomics is that between the unemployment rate and the GNP gap. Okun (1962) found that a one percentage point reduction in the unemployment rate requires an increase of 3.3 percent in the rate of growth of actual output above the growth rate of potential output. Known as Okun's Law, this relationship has been reexamined extensively over the years (Barreto and Howland, 1993; Blackley, 1991; Friedman and Wachter, 1973; Gordon, 1984; Hsing, 1991; Holloway, 1989; Knoester, 1987; Prachowny, 1993; Smith, 1975; Thirlwall, 1969; Thurow and Taylor, 1966).
In this paper we examine the sensitivity of Okun's Law to the fulfillment of price and wage expectations in the context of a model, from Friedman and Wachter (1973), that incorporates into the basic Okun's Law relation influences from the demand and supply sides of the labor market. We argue that models of Okun's Law that do not account for wage and price expectations underestimate the rate of growth of real GDP that is associated with a change of one percentage point in the unemployment rate (the required rate). Using quarterly data for the period 1958.1 - 1993.3, we estimate the required rate of growth of real GDP and find that it is the smallest when the expectations concerning wages and prices are not included in the model. On the other hand, the required rate is the largest when expected prices are allowed to deviate from their actual values.
In the next section, we present Okun's original model of unemployment and review some of the related work. This is followed by a section in which we explain Friedman and Wachter's (1973) extension of Okun's model and discuss the dependence of the unemployment--output relation on expectations. Next, we describe the data used in this study and report the result of unit root and cointegration tests. This leads to a section in which the estimation results are reported and discussed. The final section contains a summary of this work, along with some concluding comments.