RDP 2015-14: Okun's Law and Potential Output 1. Introduction

‘Okun's law’ refers to the strong correlation observed between the unemployment rate and real gross domestic product (GDP). It holds in changes and in simple transformations of the level. This paper uses Okun's law to predict changes in Australian unemployment. We also use Okun's law to estimate the growth rate of potential output as a time-varying parameter. We estimate that our definition of potential output growth has fallen from around 5 per cent in the 1970s to 2.9 per cent in 2015. An approximate 68 per cent confidence interval about the recent estimate spans 2.2 to 3.7 per cent.

Since it was popularised by Okun (1962), the term ‘potential output’ has been applied to a variety of different ideas. It can represent the permanent or smoothed component of GDP; the level of output that would obtain if prices and wages were flexible; the level of output at which resources are fully utilised; the level of output at which inflation is stable; the level of output at which some other criterion (like financial sustainability) is satisfied; and so on. Basu and Fernald (2009) and Kiley (2013) discuss the relationship between various definitions. In this paper we use a definition of potential output growth employed in the Okun's law literature: the rate of GDP growth at which the unemployment rate is stable. If the unemployment rate proxies for the overall level of resource utilisation or for the persistence of inflationary pressures, then our measure also indicates the rate of GDP growth at which these concepts are stable. We discuss our definition in Section 2.1.

It is not common for estimates of potential output to be formally evaluated. Accordingly, it can be unclear whether they are useful relative to alternatives and why they are designed the way they are. The lack of testing partly reflects the abstract, multiple or unspecified objectives of these measures, all of which make evaluation difficult. In contrast, we clearly specify the purpose of our measure, in a manner that facilitates evaluation. Our measure of potential is intended to (a) explain changes in unemployment when GDP is known, and (b) predict changes in unemployment given predictions of GDP growth. We evaluate our measure on these criteria and show that it is useful. We also have broader objectives, though these are harder to evaluate. Our estimates imply a rate of longer-term GDP growth at which the unemployment rate is expected to be stable. And if stability of the unemployment rate is a policy objective, our estimates provide a benchmark for assessing GDP growth. Our understanding is that these purposes – especially forecasting unemployment – encompass the main ways that many central banks use estimates that they call ‘potential output’.^[1]

As background, over 2014, Australian GDP grew by 2½ per cent, which the Reserve Bank of Australia (RBA) (RBA 2015, p 64) described as ‘a bit below its trend rate’. Comparisons like this are common in RBA publications, particularly in discussions of the forecasts. Although several interpretations of this ‘trend’ are possible, one consistent with our approach is that it reflects the rate of GDP growth that normally would keep the unemployment rate constant. As discussed below, we estimate that potential GDP was growing 2.9 per cent per year in 2014. Of course, the assessments of the RBA reflect a wider range of information than the simple model presented in this paper. Recently, for example, population data have also been taken into account.

In addition to providing an estimate of ‘potential output growth’ (as defined above), our paper explores the negative relationship between output and unemployment, known as Okun's law. Some of our key findings are:

• Okun's law provides a useful description of changes in the Australian unemployment rate over the past 50 years.
• Forecasts of changes in the unemployment rate based on Okun's law are about as accurate as RBA forecasts. In contrast to RBA forecasts, recent forecasts by Okun's law have been unbiased.
• The short-run relationship between output and the unemployment rate has been stable over time.
• Allowing potential GDP growth to vary over time significantly improves simpler versions of Okun's law.
• The rate of GDP growth consistent with a stable unemployment rate has fallen from around 5 per cent in the 1970s to around 2.9 per cent in 2015.
• Changes in the unemployment rate have become increasingly persistent over time.
• Okun's law is able to explain most of the asymmetry in unemployment rate changes.
• Okun's law holds in changes. We do not find that relationships in levels provide information beyond that in changes.
• We do not find that estimates of the level or change in the NAIRU are helpful for explaining or predicting changes in unemployment.

Footnote

Some estimates of the output gap have been motivated by a desire to forecast inflation. However, conversations with inflation forecasters and our reading of the literature do not indicate that output gap estimates provide useful information about the behaviour of inflation beyond that contained in the unemployment gap. See, for example, Norman and Richards (2010). [1]