On the Time‐Varying Relationship between Unemployment and Output: What shapes it?
| Author | João Tovar Jalles |
| Published date | 01 November 2019 |
| Date | 01 November 2019 |
| DOI | http://doi.org/10.1111/sjpe.12200 |
ON THE TIME-VARYING RELATION-
SHIP BETWEEN UNEMPLOYMENT AND
OUTPUT: WHAT SHAPES IT?
Jo~
ao Tovar Jalles*,**
ABSTRACT
This paper revisits, by means of both time series and panel data analyses, the
empirical regularity popularized by Okun’s (Proc Bus Econ Sect, 98-103, 1962)
seminal paper focusing on a sample of 20 advanced economies between 1978 and
2015. Not only do we provide arguably better estimates of the Okun’s Law coef-
ficient (OLC) (using the gap version) by employing a new filtering technique,
but more importantly, we also contest the hypothesis that the OLC has been sta-
tic over time. By estimating country-specific time-varying Okun coefficient mod-
els, we confirm that the unemployment-output responsiveness has been changing
over time. The dispersion between countries’ OLCs has been determined by some
(structural) characteristics. The starting level of unemployment and the phase of
the business cycle increase the estimated OLCs, while informality and certain
labour and product market policies lower them. Our evidence sustains the fact
that aggregate demand policies aiming at increasing output growth can equally
contribute to the recovery in labour markets.
II
NTRODUCTION
Okun (1962) reported an empirical regularity about a bivariate negative rela-
tionship between unemployment and output. As a result, the Okun’s Law
coefficient (OLC hereafter) constitutes one of the main macroeconomic
parameters underlying the sensitivity of unemployment movements to fluctua-
tions in economic activity. More generally, the Okun’s Law empirical relation-
ship is a main component of conventional macro-models since the aggregate
supply curve is obtained by combining Okun’s Law with the Phillips Curve
(Prachowny, 1993). Moreover, this relation has important implications for
economic policy since the size of the OLC is an indicator of the degree of
interdependence of output and labour fluctuations around their long-run
paths and is taken as a point of reference for policy makers to assess the cost
of higher unemployment. Furthermore, the effectiveness of disinflation policy
depends on the responsiveness of unemployment to the output growth rate.
*Nova School of Business and Economics
**ISEG Technical University of Lisbon
Scottish Journal of Political Economy, DOI: 10.1111/sjpe.12200, Vol. 66, No. 5, November 2019
©2018 Scottish Economic Society.
605
Despite the plethora of studies that have analysed this relation (see sec-
tion II for more details), yet another study of the OLC is still motivated by
two main considerations.
First, even though the existence of a negative relationship between the
unemployment and output seems to exist –and according to some has
remained relatively stable (Ball et al., 2018)
1
–the absolute value of the OLC
seems to have been varying over time and from country to country. Weber
(1995), Lee (2000), and Sogner and Stiassny (2002) were among the first to
provide evidence of structural (time) change in the OLC. Schnabel (2002) used
rolling regression estimates of the OLC to analyse its time path dependence.
The stability of the OLC has also been questioned more recently by several
authors using alternative statistical methodologies (Huang and Lin, 2008;
Gordon, 2010; Cazes et al., 2012; Meyer and Tasci, 2012). All in all, empirical
results seem to provide strong evidence of structural change and temporal
instability of the OLC. With this in mind, this paper moves away from typical
static estimates of the OLC and makes a novel contribution by considering
instead its temporal (non-stable) dynamics and running country-specific time-
varying coefficient models. There are several reasons why a time-varying coef-
ficient model should be superior to static-coefficient model. First, a structural
equation behind Okun’s law is subject to instabilities, which cause the coeffi-
cients in the equation of a reduced model to change. The second reason is
given by the famous Lucas critique: coefficients change if an anticipated
change in the policy regime occurs (Belke et al., 2011).
2
Second, the OLC can be considered as a reduced-form parameter, which
embeds multiple central structural parameters for the firms’ optimal demand
for labour, the labour force participation equation and the macroeconomic
production function. Consequently, and acknowledging the limitations intrin-
sic in the study of reduced-form equations, the OLC can be viewed as the net
effect of many macroeconomic structural parameters that illustrate the eco-
nomic behaviour of a given country and of the characteristics of the adjust-
ment mechanism underlying the inverse relationship between output and
unemployment over the business cycle. Moreover, with the collapse in aggre-
gate demand that followed the Global Financial Crisis, there was renewed
interest in the question of hysteresis (Belke and Gocke, 1999; Beckmann et al.,
2009), and policymakers began to question whether this should change their
approach to monetary policy. Should they raise rates in response to rising
price pressures to stay ahead of the game? Or should they wait in hopes that
unemployment turns out to be cyclical rather than structural (Coeure, 2017)?
While several studies have analysed the impact of shocks on unemployment
and its determinants (Bruno and Sachs, 1985; Blanchard and Wolfers, 2000;
Nickell et al., 2005; Bernal-Verdugo et al., 2012a,b), very few papers have
1
These authors addressed the question of the stability of the OLC focusing mainly on
country-by-country (short-run) analysis and specifying the Okun’s relationship as deviations
between the two variables under scrutiny and their long-run levels using the HP filter. They
concluded the Law to be stable in most countries.
2
We thank an anonymous referee for this comment.
606 JO
~
AO TOVAR JALLES
Scottish Journal of Political Economy
©2018 Scottish Economic Society
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