Phillips Curve and Okun’s Law

The AD AS analysis focuses on the short run when prices and quantity of some factors are
fixed
Philips Curve and Okun’s Law move the discussion to the long run when both Prices and
quantity of factors of production change. Theories, therefore, concentrated on Inflation and
deflation.
The Phillips Curve-New Zealand economist A. W. H.Phillips (Bill Phillips) in a paper in 1958
discovered a relationship between Inflation and Unemployment with empirical data from
Britain in the 19th and 20th century and noticed a negative relationship between the inflation
rate and the unemployment rate as depicted in the following diagram. Although the fit was
not exact the British data clearly showed a negative relationship between Inflation and
Unemployment.
Around the same time in 1961 economist Arthur Okun discovered an inverse relationship between
Output and Unemployment. Okun's law is an observed relationship between a country's GDP (or
GNP) and employment levels.

Okun's law was coined by Arthur Okun, a Yale economist who served on President Kennedy's council
of economic advisors.

Okun's law predicts that a 1% drop in employment tends to be accompanied by a drop in GDP of
around 2%. Likewise, a 1% increase in employment is associated with a 2% GDP increase.

The graph shows that as Output falls the unemployment increases. This relationship is called Okun’s
Law. The graph measures the cylical unemployment rate on the X axis and the real GDP gap on the Y
axis. An increasing GDP gap indicates falling output. Hence as the gap increases the cylical
unemployment rises

The compatibility of the Phillips Curve and Okun’s law can be established if we introduce the effect
of demand shocks on labour markets.

↑OUTPUT ↓ OUTPUT

Okun’s Okun’s

+ve Law -ve Law

Demand Demand
Shocks Shocks

↑ INFLATION ↓UNEMPLOYMENT ↓INFLATION ↑UNEMPLOYMENT

Phillips Curve Phillips Curve

A +ve demand shock increases aggregate demand. So producers are encouraged to increase their
production of goods and services . They hire more labour, leading to increase Output and decreased
unemployment. As more labour is hired the demand for higher wages increases and the producers
are forced to increases prices. Thus Increased Output and lower unemployment indicates Okun’s
Law marked on the right side of the triangle and decreased unemployment and increased inflation
indicates the Phillips Curve marked at the bottom of the triangle. The reverse happens in the case of
negative demand shock.

If Y is actual output (real GDP) which is the GDP corresponding to the actual rate of Unemployment
U. Y* is potential GDP i.e. GDP in normal times when the economy is neither heated or in a
recession. Y* is the potential GDP U* corresponding to the natural rate of Unemployment.

Output gap is the %difference between Y and Y* So Output gap is Y-Y*/Y*. It is positive in a boom
and negative in a slump. U* is the natural rate of unemployment. The rate of unemployment in
normal times. Cyclical unemployment is the gap U-U*. Due to bussiness cycles. It is negative in a
boom and positive in a slump

U is the actual rate of Unemployment (cyclical+ Frictional + Structural)) U* is the natural rate of
unemployment (Frictional and structural). Structural Unemployment is unemployment caused when
the skills of the worker don’t match the required skills for the jobs generated. Frictional
unemployment is a type of unemployment that arises when workers are searching for new jobs or
are transitioning from one job to another. It is voluntary unemployment. In calculations, U* is taken
as the unemployment rate of the previous year. Thus

 y = Actual GDP

 y* = Potential GDP

 β = Okun Coefficient

 u = Unemployment rate of the current year

 u* = Unemployment rate of the previous year

 y-y* = Output Gap

Y is the actual GDP which is the GDP corresponding to the actual rate of Unemployment U and Y* is
the potential GDP corresponding to the natural rate of Unemployment.