Relation between Annual Rate of Gross Domestic Product and Unemployment Rate

Overview of GDP and Unemployment rate

Economic growth is a critical macroeconomic variable monitored by policymakers. Economic growth refers to an increase in the increment of goods and services’ output over a certain period. Economic growth is accurately measured using Gross Domestic Product GDP). Gross domestic product refers to the resources spent on consumption, investment, government services and net exports. The GDP’s annual growth rate is crucial since it tracks the health of a country’s economy. The application of economic policies is dependent on the relationship between GDP and the unemployment rate.

Relation between GDP and unemployment rate

Okun’s law defines the statistical relationship between the annual growth rate of GDP and unemployment. Arthur Okun, an Economist based in the US, studied the relationship between GDP and unemployment from statistics data in the 40s and 60s and came up with an empirical observation referred to as ‘Okun rule of thumb’. Okun rule of thumb stated that an annual growth rate of GDP equal to the rate of potential output growth is usually required to maintain a stable unemployment rate (Ball, Leigh, & Loungani, 2017). The growth of the real GDP above its potential GDP is a prerequisite for decreasing the unemployment rate.

According to Okun’s law, changes in the unemployment rate is proportional to the gap between real GDP and potential GDP growth. Besides, to achieve a 1% decrease in the unemployment rate, real GDP must grow 2% faster than the growth rate of potential GDP over a specified period. The 1% change in unemployment corresponds to 2% because the coefficient proportionality used in Okun’s law is less than one. There is a negative relationship between changes in real GDP growth rates and unemployment in the long run. The critical link between GDP and unemployment is the rate of growth of potential output. If GDP is growing, more workers will be hired to create products and services and vice versa.

The growth rate of potential output is determined by the growth rate in potential productivity and the labour supply. Productivity growth refers to the increase in the value of outputs produced for a given level of inputs. Productivity growth is calculated as a ratio of GDP per worker. Where there is a lack of productivity growth, GDP growth falls below the labour force’s growth rate. A decrease in the spending of goods and services results in a reduction in the proportion of the labour force employed; thus, unemployment rises (Ball, Leigh, & Loungani, 2017).  Where productivity growth exceeds the labour force growth rate, more jobs will be created to satisfy the demand for goods and services. The positions will be filled by drawing from the pool of unemployed workers; thus, the unemployment rate falls where annual GDP growth rate equals productivity growth and labour force growth, unemployment rate rises. This is due to disparities in the number of people entering the labour force and people needed to produce the goods and services. The unemployment rate only falls where the annual GDP growth rate exceeds the labour force’s growth rate and productivity growth.

In the US, the effects of the Covid-19 pandemic wreaked havoc on the economy and employment rates. The US gross domestic product increased at an annual rate of 4.3 % in the fourth quarter but shrank 5% in the first quarter of 2020 (Amadeo & Wohlner, 2020). This was followed by a 3.5% decrease for the whole year. The decrease in the annual rate of real GDP led to an increase in unemployment rates. During the pandemic’s height, the unemployment rate skyrocketed to 14.7% as more than 4 million jobs were lost. The pandemic’s economic effects have subsided, and the US economy is expected to expand at an annual rate of 4.2%. This corresponds with the drop in the unemployment rate to 6.3% as of January 2021. The empirical Okun law is thus sufficient as the increase in the annual rate of real GDP corresponds to a decrease in unemployment rates.

 

 

References

Amadeo, K., & Wohlner, R. (2020). US Economic Outlook For 2021 and Beyond. Retrieved 13 April 2021, from https://www.thebalance.com/us-economic-outlook-3305669

Ball, L., Leigh, D., & Loungani, P. (2017). Okun’s law: Fit at 50?. Journal of Money, Credit and Banking, 49(7), 1413-1441.

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