On the Behavior of Okun's Law across Business Cycles

Abstract

Using threshold regression analysis, this paper studies how the relationship between unemployment and output, known as Okun's law, varies across business cycles measures. At the U.S. aggregate level, the results indicate the presence of strong asymmetries in the relationship characterized by three different regimes, where the sensitivity of unemployment to output decreases with economic activity for all measures of business cycles considered. For the preferred threshold variable, Okun's law is strong when the unemployment gap grows faster than 1.07 percentage points above the natural rate of unemployment, coinciding with periods of deep recessions. The sensitivity is smaller in absolute value when it grows between -0.70 and 1.07 percentage points during mild recessions, and weakens even further when the unemployment gap falls below -0.70 percentage points during periods of expansion, revealing a flattening, but also a shift, of Okun's law. The results are robust to the measure of business cycle, the specification of Okun's law, the speed of output growth, the frequency of the data and the identification of the gaps. The analysis also finds support for the nonlinear nature of Okun's law at the state and international levels.