Did Okun’s law die after the Great Recession?

Abstract

This paper estimates Okun’s law, focusing on piecewise non-linearity in the form of structural breaks and threshold dynamics, and obtains regime-dependent as well as threshold-dependent changes in the unemployment rate. We employ an autoregressive distributed lag version of Okun’s law in first differences, which allows for delayed reactions of the unemployment rate to output growth. Applied to U.S. data over 1949Q1–2015Q4, the empirical analysis characterizes Okun’s law as a three-regime relationship with the first structural break coinciding with the 1973 oil price shock, and the second structural break immediately following the end of the Great Recession. We find support for threshold dynamics in each regime, which suggests that Okun’s law follows complex non-linear dynamics. Okun’s law, as a linear and constant “rule of thumb,” breaks down in each of the three regimes. In each regime, the unemployment rate responds asymmetrically to changes in output. In sum, Okun’s law died during the Great Recession. Only time will tell whether resurrection is feasible.