Output, Unemployment and the Labour Market: The Okun Curve

After the Phillips curve, the Okun curve—the relationship between output and unemployment – is probably the most obviously nonlinear. In the growth phase of the economic cycle unemployment tends to fall steadily until the point when labour shortages are reached. In the downturn, even if it only represents slow growth, unemployment tends to rise disproportionately but with a lag. This inter-relationship, which is reflected in fluctuations in labour (and total factor) productivity, lies at the heart of the real business cycle literature and it has proved difficult to provide a totally convincing explanation that covers the whole cycle, the shocks that are experienced and the leads and lags that affect behaviour. Hiring and firing have costs. Hence firms try to take a longer-term view of their labour needs. In periods of rapid expansion they prefer to get the workforce to work longer hours and seek means of increasing productivity, albeit temporarily, if they think that the growth may be exceptional. Similarly in a downturn, if the pause is expected to be relatively short-lived, they will attempt to hold onto their labour force and reduce costs by cutting back on hours worked and limiting pay increases.