How Unemployment Affects a Country's Gross Domestic Product

This research paper will examine the relationship between Gross Domestic Product (GDP) and unemployment rates across the world, arguing that the two economic factors are in fact correlated but not necessarily in a causal relationship. The paper first discusses the existing literature on the topic, as well as the available quantitative evidence from the past century. In addition to this review, the paper compares Germany, the United States, and Canada, and looks to China’s recent changes. Overall, the paper provides a holistic view of through the application of secondary sources and brief analysis of World Bank data. Through this assessment, the paper concludes that the relationship (and Okun’s Law) stand in the modern economy.

Inverse Relationships

The Effect of Unemployment Rates on GDP (and vice versa)

“Big ideas, big ambitious projects need to be embedded within culture at a level deeper than the political winds. It needs to be deeper than the economic fluctuations that could turn people against an expensive project because they’re on an unemployment line and can’t feed their families.”

~ Neil deGrasse Tyson

Introduction

Economics is a complicated field, creating an accurate picture of a country’s economic well being involves many statistical factors. However, there are two factors in particular that all economists agree on as being significant in economic analysis: output and unemployment. First, economists have long been concerned with both the potential influences on and impact of economic output – that is, how much a country produces and subsequently grows in a given year. Since the creation of modern international economics, this has been known as a country’s Gross Domestic Product (GDP). The GDP of a country is not only an indicator of how much a country produces in a given year, but can also indicate the country’s overall economic growth when compared to GDP from previous years in the same country. This is one of the most crucial indicators of nearly anything economic – from potential growth to sustainable economic practices.

Second, rates of unemployment have an important role in determining the economic well being of any country, as they are directly related to a economy’s ability to produce and ultimately prove productive in the long run. Unemployment rates have become especially important indicators of recovery in the years following the economic recession of 2008 and 2009. In the past several years, economists and policymakers alike have looked to the unemployment rate as a sort of barometer of economic recovery. In this way, both GDP and unemployment rates are crucial to understanding economic stability and growth, and are therefore inherently tied together.

This research paper will examine the relationship between Gross Domestic Product (GDP) and unemployment rates across the world, primarily using the recent recession from 2008 as a backdrop. While the evidence for this relationship has been well established, such as through the creation of Okun’s Law, this paper takes an updated view on the subject, arguing that the two economic factors are in fact correlated but not necessarily in a causal relationship. In short, the research paper

The paper first discusses the existing literature on the topic, including an overview of Okun’s Law and secondary applications of the concept, as well as the available quantitative evidence from the past century. In addition to this review, the paper discusses several specific cases highlighting the relationship between growth and unemployment; more specifically, the paper compares Germany, the United States, and Canada to examine Okun’s law more closely, and looks to China’s recent changes as a possible exception to the coefficient.

Overall, the paper provides a holistic view of through the application of secondary sources and brief analysis of World Bank data. Through this assessment, the paper concludes that the relationship between GDP and unemployment rates (and Okun’s Law) stands in the modern economy. This is not an exhaustive account of these principal economic factors, but rather an adaptation of existing laws and research to a unique qualitative and slightly quantitative overview of the modern implications of the relationship between them – particularly as the two economic factors relate to the recovery from the 2008 recession.

Review of Literature

Economic Well-Being

One of the primary functions of economics is to determine the economic well-being and outlook of both individual economies and the global economy as a whole. Factors of this well-being and potential include economic input and output, unemployment rates, industrial growth, supply and demand, capital flows, financial crises, and more. In recent years, and more specifically since the 2008 financial crisis, economists and policymakers alike have turned to two specific factors as the main indicators of economic well-being and recovery from the recession: changes in Gross Domestic Product (GDP) and the unemployment rate. More specifically, potential GDP growth is described as “the rate of growth of real GDP that could be sustained with the economy at full employment and steady inflation” (Higgins, 2011, p. 2). Therefore, expected GDP is one of the most important factors of economic stability – and, as this paper establishes, in inherently linked to the unemployment rate in developed economies.

This has been especially true in the Western, developed countries that were hit the harest by the economic recession (Furceri & Mourougane, 2012). In fact, one study found that financial crises like the recession sparked in 2008 can “lower potential output by around 1.5-2.4% on average, with most of the impact coming from the effect on capital” (Furceri, Mourougane, 2012, 822). It is also interesting to note that these authors found that the overall impact of a financial crisis like the one in 2008 varies “according to structural features of the economies, such as the degree of openness, macro-economic imbalances, financial deepening and the quality of governance” (Furceri & Mourougane, 2012, p. 822). This is something that will be assessed in this paper’s subsequent discussion, but for now it is sufficient to acknowledge that Western economies’ recovery is largely dependent on GDP and unemployment rates – and the empirical (if not causal) relationship between the two.

It is also important to note at this point the importance of considering longitudinal data in determining economic well-being. As Baumol (1986) stated nearly thirty years ago, “Anxiety may compel attention, but it is not necessarily an aid to clear thinking” (p. 1072). The economist goes on to state that concerns regarding long-run economic growth do not necessarily “recognize that adequate economic analysis of such issues calls for the careful study of economic history” (Baumol, 1986, p. 1072). In other words, determining economic recovery and well-being is largely a process of historical economic analysis. The author concludes that considering the ‘long run’ is important “because it is not sensible for economists and policymakers to attempt to discern long-run trends and their outcomes from the flow of short-run developments, which may be dominated by transient conditions” (Baumol, 1986, p. 1084). In this way, the present research paper attempts to draw from historical data as well as economic changes since 2008. Policymakers and academics alike would do well to consider overall historical trends when assessing the relationship between GDP and unemployment rates.

Okun’s Law

At nearly fifty years old, Okun’s law (or coefficient) has proven to be one of the most accurate and long-lasting empirical relationships in macroeconomics. Most economic literature that today assesses the relationship between GDP and unemployment rates, particularly as signals of economic recession or recovery, draw from this established empirical relationship. As Higgins (2011) states, Okun’s law essentially describes the relationship as follows: “If GDP grows rapidly the unemployment rate declines, if growth is very low or negative the unemployment rate rises, and if growth equals potential the unemployment rate remains unchanged” (p. 2). In other words, there is an inverse empirical relationship between the unemployment rate and the GDP in any given country; as GDP rises, unemployment rates decrease, and vice versa. This theory was developed by Okun in 1962, based off of data from 1947 to 1960 (Okun 1962). More specifically, the coefficient that Okun created predicted that “each percentage point of the unemployment rate above four percent was associated with the real GNP being lower by approximately three percent” (Fidrmuc & Huang, 2015, p. 2). Over fifty years after this empirical contribution, Okun’s coefficient (now known as “Okun’s law”) is still accepted as a fundamental empirical relationship in macroeconomics.

Owyang, Vermann, and Sekhposyan (2013) provide a detailed overview of Okun’s law, and present a graph to highlight the empirical relationship. The graph is reproduced here.

The Okun’s Law Relationship

Owyang, Vermann, & Sekhposyan, 2013, p. 2.

The authors explain that Okun attempted to identify the relationship between two variables: “the difference between the actual level of output and its potential” and “the difference between unemployment and its natural rate” (Owyang, Vermann, & Sekposyan, 2013, p. 2). By way of explanation, the authors state, “potential output is not the maximum an economy could theoretically produce, but a lower, sustainable number” (Owyang, Vermann, & Sekposyan, 2013, p. 2). In this way, Okun’s law is more of a description of the relationship between factors that affect economic growth, rather than a static, unchanging relationship.

Modern Applications

While more specific applications of Okun’s law to the recent economic recession and recovery will be provided in the subsequent discussion, it is worthwhile to mention how Okun’s coefficient has withstood economic testing over the past half-century. For the most part, the empirical relationship has stood up to the test of time, and most economists agree that the relationship has proven true over the past fifty years of economic change (Fidrmuc & Huang, 2015; Hoffman & Lemieux, 2014; Burgen, Meyer, & Tasci, 2012). However, this is an important caveat in the continued acceptance of Okun’s law: that there is a relationship, but not necessarily a causal one. As Burgen, Meyer, and Tasci (2012) conclude, it is crucial to recognize “that Okun’s law is just an empirical relationship. It may not necessarily reflect a structural link between output growth and unemployment rate. Moreoever,the relationship might change over time as the dynamics of the labor market change” (n.p.). Similarly, Fidrmuc and Huang (2015) clarify that the law is “an empirically observed rather than theoretically derived relationship” and there “stipulates correlation and says little as to whether the direction of causality goes from growth to unemployment or the other way around” (p. 5). Therefore, the subsequent discussion of case studies and empirical evidence does not attempt to establish a causal relationship, but merely an overview of the modern adaptation to Okun’s law.

GDP, Unemployment Rate, and Economic Growth

According to the average political pundit or economic commentator, the economic implication of Okun’s law following the 2008 financial crisis is simple enough: “we must get the American worker back into the labor force” (Patton, 2012, n.p.). It seems that the simplest way to drive economic growth is to decrease the unemployment rate, which should in turn increase output and GDP. However, like with most economic relationships, it is not a simple matter of adjusting one economic factor to better the other. As already noted above, the relationship between GDP and unemployment is established, but not necessarily causal.

Therefore, instead of focusing on causation, the subsequent discussion addresses the relationship between GDP and unemployment in terms of modern examples of economic recovery following the financial crisis in 2008. More specifically, the discussion turns to three primary Western economies – the United States, Germany, and Canada – to compare economic trends and recovery both leading up to and following the recent recession. The discussion also turns to China’s economy as an example of a potential exception to Okun’s law and the inferred relationship; more specifically, China’s economic changes highlight the fact that Okun’s law regarding the relationship between GDP and unemployment may only be applicable to already developed and stabilized Western economies. This discussion utilizes two aspects of assessment: the findings of secondary sources regarding these countries specifically, as well as an original quantitative description of the economic changes in these four countries since 2007, using World Bank Data.

Secondary Sources on Western Economies and China

As mentioned above, there have been a great many studies in the past half century to confirm Okun’s law throughout economic fluctuations, financial crises, and historical change. For example, one study found that the relationship only varied slightly in its “responsiveness” to unemployment – using data from 1948 to 2007, one researcher found that Okun’s coefficient “decreased dramatically in the 1990s and has since remained at a lower level” (Owyang & Sekhposyan, 2012, p. 399). The main point, however, is that the relationship has remained true, and it should prove beneficial to look at evidence from specific countries.

This paper has already discussed the fact that the relationship between GDP and unemployment has remained largely the same in OECD countries between 1960-2008 (Furceri & Mourougane, 2012). But what does the picture of this relationship look like in specific OECD countries? There are several studies that assess this. First, Hoffman and Lemieux (2014) examine levels of unemployment during the so-called “Great Recession” in three primary Western economies: Germany, Canada and the United States. More specifically, the paper investigated “the potential reasons for the surprisingly different labor market performance of the [three countries]…during and after the Great Recession of 2008-2009” (Hoffman & Lemieux, 2014, p. 1). By way of primary findings, the paper found that the percentage changes in unemployment in the three countries varied dramatically: unemployment remained relatively stable in Germany, rose slightly in Canada, and increased to dramatically higher levels in the United States (Hoffman & Lemieux, 2014). Since the Great Recession affected nearly every Western economy, one would expect all three countries to see a dramatic change in unemployment rate, along with a decrease in the GDP growth rate. So, why then, has the United States experienced a much greater change in unemployment in recent years?

The answer, according to this paper, is two-fold: first, “employment swings in the construction sector linked to the boom and bust in U.S> housing markets can account for a large fraction of the cross-country differences,” and second, “relative to pre-recession trends there has been a much larger drop in GDP in the United States than Germany between 2008 and 2012” (Hoffman & Lemieux, 2014, p. 2). While the first finding is not necessarily or inherently crucial to this paper’s discussion of GDP growth and unemployment rates, it does provide insight into the reiteration that Okun’s law is an empirical observation rather than a causal relationship. In other words, the fact that the makeup of the labor market in the United States as being largely focused around the construction industry during the housing boom affects the outcomes of Okun’s coefficient serves as a reminder that the economy does not respond well to a “quick fix”. It is multifaceted, and the relationship between GDP and unemployment rates is just one part of growth (or lack thereof).

The second finding from this paper, however, highlights the continued validity of Okun’s law. The relationship between GDP and unemployment is reconfirmed by just a little bit of economic research; simply put, the United States was hit the hardest by the financial crisis of 2008, and therefore experienced the largest fluctuations in both GDP and unemployment rates. As the authors state, “Differences in unemployment performance between the United States and Germany are very much in line with observed difference in GDP performance” (Hoffman & Lemieux, 2014, p. 4). More specifically, the authors find that the Okun relationship predicts that the 10 percentage point gap in GDP between the two countries would translate into a 5 percentage point difference in the two countries’ unemployment rates; this is less than two percentage points off of the actual difference, which is 6.5 percentage points (Hoffman & Lemieux, 2014, p. 7). Therefore, the relationship appears to stand in the assessment of the Canadian, American, and German economies’ performance.

The relationship is further highlighted by the graph from Burgen, Meyer, and Tasci (2012) from their discussion of the modern application of the coefficient:

Representation of Okun’s Law, using US data

These authors’ analysis drew from the last twenty years of data, and found no change in the applicability of Okun’s law through the financial crisis and recovery. Like with the assessment above, these scholars found that the percentage change in real GDP held a relatively stable relationship with the percentage change of unemployment rates from 2009 to 2011, the primary years of recovery.

China

The discussion of China in relation to this relationship between GDP and unemployment also yields insight into the applicability of the relationship in the modern economy. First of all, scholars do recognize the relationship between labor force numbers and productivity, even in the fast-paced economic environment of China. One paper found that “an increase in labor force participation and improvement in total factor productivity can significantly enhance the potential GDP growth rate” (Cai & Lu, 2013, p. 1). However, there are some important exceptions that make China’s economy a distinct case. As Fidrmuc and Huang (2015) state, their study found “considerable differences in the nature of this relationship across Chinese regions,” and ultimately argue that Okun’s law and the relationship between GDP and unemployment applies differently in transitional economies. (p. 1). In other words, the relationship may not apply in China because the factors affecting its economy are so much greater.

The authors state that the ‘law’ was created within the US, with a “mature market economy” – in contrast, China “has been undergoing a dramatic and multi-faceted transition since 1978” (Fidrmuc & Huang, 2015, p. 2). Therefore, the authors find that the economic transition in China had a much larger impact on the overall growth rate (GDP) and unemployment (or lack thereof) than the two factors had on each other. Even during its transition, China has maintained a centrally located and planned economy – ostensibly to this day. In this way, it is more the government and transition itself that affect overall growth. The authors also found in other countries that the Okun’s relationship “emerges in transition countries only after the transformation has progressed” (Fidrmuc & Huang, 2015, p. 5). Therefore, this relationship may become applicable in China once the economy is full transitioned into a free market economy.

Primary Data Assessment

In addition to reviewing the secondary sources discussed above, this paper also conducted an original assessment of the available data regarding GDP and unemployment rates within the United States, Germany, Canada, and China. This data is available from the World Bank.

These figures, represented using an available online tool on World Bank, visually reflect the findings discussed above. The most striking feature of these representations is that the United States has the largest unemployment rate relative to China in 2009, the year immediately following the financial crisis of 2008. This reflects two of the points from above: first, that the United States was hit the hardest by the recession because it suffered the largest percentage decrease in GDP growth, and that China went relatively unaffected by this recession because its economy is driven by so many different factors at once, as it transitions. The second element of this representation is a reaffirmation of Okun’s law: one can easily see that all three of the Western economies (Germany, the United States, and Canada) experienced a decrease in the unemployment rate beginning in 2010, the same year that GDP growth began to pick up. Therefore, even a cursory examination of the available data reaffirms the relationship between economic output (GDP) and unemployment rates.

Conclusion

This research paper has examined the relationship between a country’s Gross Domestic Product and its unemployment rate. In addition to an initial review of literature on the economic topic, the paper utilized both secondary data and primary collection from the World Bank to reestablish the empirical relationship between these two economic factors. Case studies from three Western economies (Germany, Canada, and the United States) and China provided more detailed insight into how this relationship behaves across various economic structures and historical developments. While this discussion is certainly not exhaustive, it does reaffirm the continued validity of Okun’s law and prove information in the way the relationship interacts in individual economies.