# Okun’s Law: A Meaningful Guide for Monetary Policy?

^{1}The x-axis shows the change in the unemployment rate relative to its natural rate (also defined as its long-run HP trend). Each dot in the chart represents the observed changes in GDP and unemployment in a particular year. The solid line through the dots is the fitted value of the relationship, which captures the average slope (–1.8) of the two variables. Thus, this empirically estimated Okun’s law states that for each 1-percentage-point increase (decrease) in the unemployment rate from its natural rate, total output on average will be lowered (raised) by nearly 2 percent relative to its long-run HP trend. For example, suppose the natural rate of unemployment is 6 percent in 2012; then the current 8.1 percent unemployment rate implies that real GDP is about 3.6 percent below its potential trend.

_{t}), the HP trend (the solid red line ), and the mean (the straight line u

^{*}). Notice how the HP trend closely tracks the movements in the actual rate of employment, suggesting that the long-run rate of unemployment is not a constant over time. For example, the high unemployment rate since the financial crisis is mainly driven by a rising long-run trend in the natural rate. Judged by this trend, the current 8.1 percent unemployment rate is already about 0.3 percentage points below its natural rate (which, under the conditions of this panel of the chart, would be 8.4 percent for 2012:Q2),

^{2}suggesting that output is already 0.54 percent above its long-run trend. Thus, further monetary stimulus packages may no longer be needed. In sharp contrast, the mean unemployment rate (the straight line u

^{*}) is around 6 percent through the sample period. Judged by this second trend, the current unemployment rate is still more than 2 percentage points above its natural rate. Using the alternative Okun’s law (lower-right panel), output would still be more than 1 percent below its long-run trend. However, given the large standard errors in the alternative Okun’s law, we are not confident that this 1 percent output gap is credible; it could equally likely be 2 percent or 0 percent.

^{1}The HP trend of a variable captures not only the variable’s constant growth rate but also slow-moving fluctuations. The HP trend is obtained by applying the Hodrick-Prescott (HP) filter.

^{2}Since the endpoint of the HP trend cannot be estimated accurately, we extended the data by six more quarters using an autoregressive moving average forecast model.

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