JULY
2010

 

By
Larry DeBoer
 
Professor of
Agricultural Economics
Purdue University

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7-22-10

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Okun and Phillips and Our Economic Recovery


We're waiting for the economy to recover. We'd like the unemployment rate to get back to where it was before the recession started. The rate averaged 5 percent from 2004 to 2007. It was 9.5 percent in June. That's down from 10.1 percent last October. Down is the right direction, but the rate is still way too high.

How long will it stay high? A long time, probably. The last time the unemployment rate was 9.5 percent was August 1983. That was just after the last "Great Recession." It didn't reach 5 percent until March 1989, almost 6 years later.

There's a measure of the relationship between economic growth and the unemployment rate called Okun's Law. It's named after Arthur Okun, an economist who worked for the Kennedy and Johnson administrations. He figured out the link between economic growth, measured by inflation-adjusted gross domestic product (GDP), and changes in the unemployment rate.

Okun's colleagues at the Council of Economic Advisors were just kidding around when they named his equation a law. The relationship has changed over the years, but, since 1987, the GDP needs to grow about 2.8 percent per year to keep the unemployment rate steady. Sure enough, GDP growth has averaged 3.4 percent since July 2009, and the unemployment rate is down by six-tenths of a point.

We'd like unemployment to drop faster. GDP has to grow about 4.5 percent in a year to bring the unemployment rate down by a whole percentage point. One reason why it takes so much growth to reduce unemployment is that new jobseekers keep entering the labor force. More than a million-and-a-half people join the labor force in a typical year. The economy has to grow to create new jobs for all these new workers.

Suppose that GDP does grow by 4.5 percent a year. If it keeps growing that fast, the unemployment rate will fall by about a point a year, and the unemployment rate will reach 5 percent in four-and-a-half years. That's the end of 2014. The problem is that GDP has grown by 4.5 percent for a full year only twice since 1987. That much growth in a single year is pretty rare. The unemployment rate is likely to be above 5 percent into 2015 and beyond.

If we can guess about unemployment we can guess about inflation, using another relationship called the Phillips Curve. This example is named after A.W. Phillips, an economist from New Zealand (although he worked in London), who first looked at a different link to the unemployment rate in 1958. However, no one calls the Phillips Curve a law: Maybe because it's a weaker relationship than Okun's, or maybe because Phillips' colleagues weren't such a fun-loving bunch.

The Phillips Curve says that high unemployment brings the inflation rate down. When unemployment is high wages don't increase much, so business costs don't rise. Consumers spend less, too. Businesses don't raise prices much in an economy like that.

Since 1987 there have been seven years when the unemployment rate was 6 percent or above. In six of those seven years the inflation rate fell from the year before. The exception was 1987, when inflation went up a mere tenth of a point.

Okun's Law says that the unemployment rate is likely to be above 6 percent into 2014, at least. That means the inflation rate will keep falling, according to the Phillips Curve. The "core" inflation rate has been 1 percent over the past year (that's inflation not counting the ups and downs of oil and food prices). It's so low now that if it keeps falling it could turn negative. That's deflation, and that's a problem. Deflation tends to keep consumers from spending, because they expect prices to be lower in the future. If consumers don't spend, it's hard to get GDP growing.

If GDP grows slowly, Okun says that unemployment won't fall very fast. If unemployment stays high, Phillips says that inflation will decline and perhaps become deflation. If we have deflation, consumers won't spend, and GDP will grow slowly. And that brings us back to Okun.

Who can prevent this vicious cycle? The Federal Reserve is the likely candidate. The Fed has created a lot of money over the past few years. If deflation is a threat, maybe they'll have to create some more.

 

 

Writer: Larry DeBoer
Editor: Olivia Maddox