Testing Okun's Law Over the Business Cycle: The Case of South Africa

Abstract

ABSTRACT: Understanding the relationship between output and unemployment (Okun's law) is important for policymakers, particularly during crises. One of the aspects of Okun's law that is commonly examined during crises is the structural stability and behavior of Okun's law over the business cycle. While this issue has been addressed empirically in developed countries, little is known about it in developing countries such as South Africa. Hence, this study examines the structural stability and behavior of Okun's law over the business cycle in South Africa. This study adopts both the difference and gap methods of formalizing Okun's law to implement its objectives. The recursive rolling window method was used to test the structural stability of Okun's law over time. The behavior of Okun's law over the business cycle is examined using the Markov-switching regression method. This study was conducted using the data from 1994Q1 to 2021Q1. The results of this study show that Okun's law varies over the business cycle because the response of unemployment to economic expansion is quite different from that of economic contraction. Okun's law holds during economic expansion but fails to hold during an economic recession. Evidence from this study also reveals that the coefficients of Okun's law vary over time. For instance, in the case of the difference method, Okun's coefficients range from 0.063 to 1.221 in absolute terms. For the gap method, especially when the H-P filtering method is applied, Okun's coefficients range from 0.509 to 9.412 in absolute terms. In summary, the findings from this study suggest that cyclical unemployment responds more significantly to cyclical output growth than the response of changes in unemployment to changes in output. In addition, this study proves that Okun's law is unstable over time in South Africa. These findings imply a high degree of variability between the labor and goods markets in the country. Hence, policies must be designed to harmonize the divergence between the two markets. This will require the implementation of macroeconomic policies such as fiscal and monetary policies. From a fiscal policy perspective, the government should reduce taxes or provide tax holidays to firms. The interest rate should be set low in the case of monetary policy.