Friday, July 24, 2009

Recession and the broken Okun's law

In economics, Okun's Law states the relationship between unemployment and GDP gap. It states that for every 1% increase in the unemployment, the GDP will decrease by 2% of its potential GDP. This is an emphirical based on observation rather than theory. So conversely it looks reasonable to assume that for every 2% reduction in GDP gap, a 1% reduction in unemployment can be expected.

But the problem is Okun's law does not always work and especially it is broken in recessions. As a result, we may have a GDP recovery ending the recession and even starting the growth, but the unemployment rate would remain as such in the verge of 10%. It's a bad news, but unfortunately some of the liberal economists that I respect (Bradford DeLong, Nouriel Roubini a.k.a. Dr. Doom) suggest so.

UPDATED ON 1st AUGUST: Paul Krugman predicts jobless recovery with recent GDP figures.
UPDATED FOR CORRECTION: Actually Paul Krugman says Okun's law behaves itself now. My misunderstanding. But the question is, would it during GDP recovery? I don't think so.

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