No Such Thing as a Free Lunch: Principles of Economics (Part 159)

Macroeconomic policy can never be devoid of politics: it involves fundamental trade-offs and affects different groups differently.

Joseph Stiglitz

Household and Firm Behavior in the Macroeconomy: A Further Look

(Part I)

by

Charles Lamson

The Relationship between Output and Unemployment

We can now also use what we have learned about household and firm behavior to analyze the relationship between output and unemployment. Output (Y) and the unemployment rate (U) are inversely related. When output rises, the unemployment rate falls, and when output falls, the unemployment rate rises. At one time, it was believed that the relationship between the two variables was fairly stable. Okun's Law (after Arthur Okun, who first studied the relationship) stated that the unemployment rate decreased about 1 percentage point for every 3 percent increase in real GDP. Okun's Law has not turned out to be a "law." The economy is far too complex for there to be such a simple and stable relationship between two macroeconomic variables.

Although the relationship between output and the unemployment rate is not the simple relationship Okun believed, it is true that a 1 percent increase in output tends to correspond to a less than one percentage point decrease in the unemployment rate. In other words, there are a number of "slippages" between changes in output and changes in the unemployment rate.

The first slippage is between the change in output and the change in the number of jobs in the economy. When output increases by 1 percent, the number of jobs does not tend to rise by 1 percent in the short run. There are two reasons for this. First, a firm is likely to meet some of the increase in output by increasing the number of hours worked per job. Instead of having the labor force work 40 hours per week, the firm may pay overtime and have the labor force work 42 hours per week. Second, if a firm is holding excess labor at the time of the output increase, at least part of the increase in output can come from putting the excess labor back to work. For both reasons, the number of jobs is likely to rise by a smaller percentage than the increase in output.

The second slippage is between the change in the number of jobs and the change in the number of people employed. If I have two jobs, I am counted twice in the job data but only once in the persons-employed data. Because some people have two jobs, some of the new jobs are filled by people who already have one job (instead of by people who are unemployed). This means the increase in the number of people employed is less than the increase in the number of jobs. This is a slippage between output and the unemployment rate because the unemployment rate is calculated from data on the number of people employed, not the number of jobs.

The third slippage concerns the response of the labor force to an increase in output. Let E denote the number of people employed, let L denote the number of people in the labor force, and let u denote the unemployment rate. In these terms, the unemployment rate is:

u = 1 - E / I

The Discouraged Worker Effect A discouraged worker is one who would like a job but has stopped looking for one because the prospects seem so bleak. When output increases, job prospects begin to look better, and some people who had stopped looking for work begin looking again. When they do, they are once again counted as part of the labor force. The labor force increases when output increases because discouraged workers are moving back into the labor force. This is another reason the unemployment rate does not fall as much as might be expected when output increases.

These three slippages show that the link from changes in output to changes in the unemployment rate is complicated. All three combine to make the change in the unemployment rate less than the percentage change in output in the short run. They also show that the relationship between changes in output and changes in the unemployment rate is not likely to be stable. The size of the first slippage, for example, depends on how much excess labor is being held at the time of the output increase, and the size of the third slippage depends on what else is affecting the labor force (like changes in real wage rates), at the time of the output increase.

The relationship between output and unemployment depends on the state of the economy at the time of the output change. 

*CASE & FAIR, 2004, PRINCIPALS OF ECONOMICS, 7TH ED., PP. 625-626*

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