Using Okun's Law

One of the goals of economic policy is to keep the economy operating close to potential output, or the full-employment level of output. Determining output gaps - the difference between potential and actual output - is a difficult task for policymakers. One tool that economists use to estimate the size of the output gap is Okun's Law, a "rule of thumb" that describes in quantitative terms the relationship between cyclical unemployment and the output gap.

Exploration: What's the relationship between output gaps and cyclical unemployment and how can it be used to guide policymakers?

The applet above gives the actual unemployment rate, the natural unemployment rate, potential real GDP, the size of the output gap measured in both percentage (relative to potential GDP) and actual dollar terms, the type of output gap, if any, and the amount of cyclical unemployment, for the years 1982, 1991, and 1998. You can change the actual and natural unemployment rate, as well as the level of potential GDP, and analyze the change in the output gap. Click the Reset button to restore the original values.

1. In the New row, change the actual unemployment rate to 7.0%. What happens to cyclical unemployment and the output gap? In this situation, what would policymakers want to do if their objective was to keep the economy close to potential GDP?
   
   
2. Click the Reset button to restore the original values in the table. If the natural rate of unemployment, u*, falls while the actual level of unemployment remains the same, what happens to the output gap and cyclical unemployment in the economy?
   
   
3. Click the Reset button to restore the original values in the table. If the actual rate of unemployment, u, rises while the natural rate of unemployment remains the same, what happens to the output gap and cyclical unemployment in the economy?
   
   
4. Click the Reset button to restore the original values in the table. The U.S. unemployment rate reached a 30-year low of 3.9% in April, 2000, well below most economists' estimate of the natural rate of unemployment. Now, in the New row, change the actual unemployment rate to 3.9% and potential GDP to $9,999. What happens to the GDP gap and cyclical unemployment, relative to the 1998 figures?
   
   
5. Given the economic conditions outlined in problem #4, how should policymakers react to this change in the output gap? Why?
   
   
6. Again, given the economic conditions outlined in problem #4, how could the actual unemployment rate continue to fall through April, 2000 without the expansionary output gap becoming so large that policymakers felt a need to react and slow the economy down?
   

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