Did Okun's Law Die after the Great Recession?
Business Economics, October 2017
36 Pages Posted: 20 Aug 2016 Last revised: 26 May 2018
Date Written: August 19, 2016
This paper proposes an empirical framework to estimate Okun's law which focuses on structural breaks and threshold nonlinearity. We use sequentially the Bai and Perron’s (1998, 2003) structural break and threshold methodology to enable 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 changes. Applied to US data (1948Q1-2015Q4), the empirical analysis characterize Okun’s law as a three-regime relationship with the first break coinciding with the 1973 oil shock, and the second break immediately following the end of the Great Recession. In the post-Great Recession regime, we find that Okun’s law breaks down as a linear relationship. This result assumes a linear and symmetric relationship between changes in the unemployment rate and real output. We test this assumption for each of the identified regimes using threshold estimation and recognize a threshold within each regime, which rejects the linearity and symmetry hypotheses and, thus, suggests that Okun’s law follows a more complex nonlinear asymmetric dynamics. Importantly, when we apply threshold estimation to the post-Great Recession regime, we find that the time-honored link between output growth and the unemployment rate still holds.
Keywords: Okun's law; structural breaks; threshold effects
JEL Classification: C14; E31; C22
Suggested Citation: Suggested Citation