ELS Chapter 10: Graphing Exercise Answers
Using Okun's Law
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?
  answer: Cyclical unemployment is the difference between the actual unemployment rate and the natural rate of unemployment. Because the actual unemployment rate increased while the natural rate of unemployment stayed the same, cyclical unemployment increases to 1.8% from -0.70, while the output gap rises to 3.6% of potential GDP. In dollar terms, the output gap rises to $308 billion. To keep the economy close to potential GDP (to close the output gap) policymakers would need to increase aggregate expenditures in the economy. They could accomplish this task by reducing taxes, increasing government spending, or reducing interest rates.
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?
  answer: The output gap and cyclical unemployment both get larger (or less negative in the case of an expansionary gap. To see this, reduce the natural rate of unemployment to, say, 4.8%, leaving the actual unemployment rate at 4.5%, the 1998 value.
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?
  answer: The output gap and cyclical unemployment both get larger (or less negative in the case of an expansionary gap. To see this, increase the actual rate of unemployment to, say, 4.8%, leaving the natural rate of unemployment at 5.2%, the 1998 value.

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?
  answer: Because the actual unemployment rate is lower than the natural rate of unemployment, the output gap is negative. The economy is experiencing an expansionary gap of 2.6% of potential output, or $260 billion, which is almost double (in percentage terms) the size of the output gap in 1998.

5.

 Given the economic conditions outlined in problem #4, how should policymakers react to this change in the output gap? Why?
  answer: Large expansionary gaps can lead to higher inflation, so policymakers often take measures to slow down spending in the economy, such as raising taxes, reducing government spending, or increasing interest rates, when this occurs.

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?
  answer: The analysis in problems #2 and #3 assumes that the natural rate of unemployment did not change. If the natural rate of unemployment is falling at the same time that the actual unemployment rate is falling, the output gap may not be increasing (do this in the table). This helps to explain why policymakers were not overly alarmed by the unemployment rate falling to 30-year lows.