Suppose based on the past twenty years of data the estimating equation for Okun’s Law is ut – ut-1 = –0.4 (gt – g*), where g*, the normal (or benchmark) growth rate of output, is equal to 3%. If the current rate of unemployment is 9% what is the minimum growth rate of output needed over five years to reduce the unemployment rate to 5%?
Question
Suppose based on the past twenty years of data the estimating equation for Okun’s Law is ut – ut-1 = –0.4 (gt – g*), where g*, the normal (or benchmark) growth rate of output, is equal to 3%. If the current rate of unemployment is 9% what is the minimum growth rate of output needed over five years to reduce the unemployment rate to 5%?
Solution
To solve this problem, we first need to determine the total reduction in unemployment needed. This is given by the difference between the current unemployment rate and the desired unemployment rate, which is 9% - 5% = 4%.
Next, we use Okun's Law to find the total increase in output growth needed to achieve this reduction in unemployment. Okun's Law states that for every 1% decrease in unemployment, output growth needs to be 0.4% above the normal growth rate. Therefore, to achieve a 4% decrease in unemployment, output growth needs to be 4 * 0.4 = 1.6% above the normal growth rate.
Finally, we add this increase to the normal growth rate to find the minimum growth rate of output needed. The normal growth rate is given as 3%, so the minimum growth rate of output needed is 3% + 1.6% = 4.6%.
Therefore, to reduce the unemployment rate from 9% to 5% over five years, the minimum growth rate of output needed is 4.6% per year.
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