Unemployment and Economic Growth

Unemployment and Economic Growth

Order Code RS21139
February 5, 2002
CRS Report for Congress
Received through the CRS Web
Unemployment and Economic Growth
Brian W. Cashell
Specialist in Quantitative Economics
Government and Finance Division
Summary
Economic growth and the unemployment rate are very closely related. The
connection is such a stable one that it is often referred to as “Okun’s law,” after an
economist who pointed it out. In the long run, economic growth is a function of
increases in labor and in productivity. For economic growth to accommodate growth in
the labor force without leading to a rise in the unemployment rate, it must at least equal
the combined growth rates of labor and productivity. Over the last 50 years, the rate of
economic growth required to keep the unemployment rate from rising has been, on
average, close to 3.5%. Over relatively shorter periods of time, the rate may have
fluctuated due to shifts in either labor force or productivity growth. Although labor
force growth has slowed over time, the trend rate of productivity growth may have
accelerated in the second half of the 1990s. Recent estimates put the combined rate of
growth of labor and productivity at about 3.5%. If that is true, that is the rate that would
be consistent with a stable unemployment rate. Economic growth below that rate would
lead to a rising unemployment rate, and economic growth above that rate would likely
lead to a falling rate of unemployment. In the very short run, there may be variations in
the unemployment rate due to factors other than the rate of economic growth. Over
longer periods of time, however, it may take economic growth in excess of 3.5% to
achieve substantial reductions in the unemployment rate. This report will not be updated.

In the long run, real economic growth is the means by which the nation achieves
improving living standards. Over the long run, the faster the economy grows, the better
off we are materially. In the short run, however, the rate of growth has consequences for
a number of other economic variables. If economic growth persists at too rapid a rate,
there is a risk that inflation may accelerate.1 If economic growth is too slow, then there
is a risk of rising unemployment. Although rising unemployment is typically associated
with economic contractions, or recessions, it is entirely possible for the economy to be
growing yet not rapidly enough to prevent the unemployment rate from rising. This has
1 See: CRS Report RL30391, Inflation and Unemployment: What is the Connection?, by Brian
W. Cashell.
Congressional Research Service ˜ The Library of Congress

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been referred to as a “growth recession.” Knowing what the rate of economic growth is
that is necessary to reduce the unemployment rate, or at least to keep it from rising, would
be of considerable use to policymakers.
What Is the Connection?
That there is a stable relationship between the rate of economic growth and changes
in the unemployment rate was most famously pointed out by economist Arthur Okun,
which is why it is now referred to as “Okun’s Law.” More recently, it was included in a
list of “core ideas” that are widely accepted in the economics profession.2
The key to the relationship between the rate of economic growth and the
unemployment rate is the rate of growth of what economists refer to as “potential output.”
In brief, potential output is a measure of the capacity of the economy to produce goods
and services given the available resources, such as labor and capital.
The rate of growth of potential output is a function of the rate of growth of
productivity, and the rate of increase of the contribution of the labor force in the
production of goods and services.
Labor’s contribution to output is, in turn, determined by the size of the population,
the share of the population that is in the labor force, the share of the labor force which is
actually employed, and the hours worked by those who are employed. Ultimately, labor
input is measured in terms of hours.
If, for the sake of simplicity, it can be assumed that the hours worked by those who
are employed remain constant, then the contribution of labor to total output depends on
the size of the labor force, and the proportion of it that is employed.
The labor force consists of those who are either working or who are looking for
work. In the absence of productivity growth, as long as each new addition to the labor
force is employed, growth in total output will just equal the growth in the labor force. If
growth in output falls below the rate of growth of the labor force, then there will not be
enough new jobs to accommodate additions to the labor force. The proportion of the
labor force that is employed will fall, and the unemployment rate will rise.
If growth in output exceeds the rate of growth in the labor force, some of the new
jobs opening up will only be filled by drawing down the pool of unemployed labor. If
there is considerable slack in the economy this does not pose a problem, but if
unemployment is already at relatively low levels then the increased demand for labor is
more likely to be satisfied by rising wages than by higher levels of employment and there
may be a risk of accelerating inflation.
If productivity is rising, over time it will take fewer and fewer workers to produce a
given quantity of goods and services. If growth in output only matches the growth rate
2 Blinder, Alan. “Is There A Core of Practical Macroeconomics That We Should All Believe,”
American Economic Review, volume 87, number 2, May 1997, pp. 240-243.

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of the labor force, then growth in the labor force will exceed what is necessary to produce
the higher levels of output. The share of the labor force employed will fall, and the
unemployment rate will rise. Only as long as the growth in output equals the combined
growth rates of the labor force and productivity will the unemployment rate remain
constant. Knowing what that rate is would be useful to policymakers. Depending on the
economic situation it might be desirable to strive for actual economic growth at, above,
or even below that rate of growth.
Figure 1 shows the relationship between economic growth and changes in the
unemployment rate graphically. Each point in the graph refers to a particular quarter of
a year and indicates a pair of observations. The first observation of each pair is the change
in real GDP over the previous four quarters (shown on the horizontal scale). The second
observation of each pair is the percentage point change in the civilian unemployment rate
over the same period (shown on the vertical scale). The data reflect the U.S. experience
since 1949.
Figure 1. Real Economic Growth and the Unemployment Rate
4
3
2
1
0
-1
change in unemployment rate
-2
-3
-5 -4
-3 -2 -1
0
1
2
3
4
5
6
7
8
9
10 11 12 13 14 15
economic growth rate
The solid line in the graph indicates the estimated statistical relationship between
economic growth and changes in the unemployment rate based on the actual data plotted.
Clearly, there is a strong link between the rate of economic growth and changes in the
unemployment rate. Based on the estimated relationship between the two variables over
the entire period, real economic growth of about 3.5% was associated with a stable
unemployment rate. When economic growth was faster than 3.5%, the unemployment rate

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tended to fall, and when economic growth was below that rate the unemployment rate
tended to rise.
There are times, however, when the relationship breaks down. Changes in
productivity growth tend not to be correlated with changes in unemployment. In the short
run, a rise in productivity can produce an increase in the economic growth rate without
necessarily pushing down the unemployment rate. For example, in 1993 the
unemployment rate fell to 6.9% from 7.5% in 1992. But at the same time economic
growth in 1993 fell to 2.7% from 3% in 1992. The reason was a brief surge in
productivity growth in 1992.3
In the long run, labor market conditions are important determinants of the
unemployment rate. Changes in the labor market may also cause the relationship between
economic growth and the unemployment rate to break down.4
Over the course of a year, a one percentage point difference in the economic growth
rate led to a change in the unemployment rate of about 0.4 percentage points. In other
words, while economic growth of 3.5% was sufficient to maintain a stable unemployment
rate, an annual increase in real output of 4.5% was associated with a one-year decline in
the unemployment rate of 0.4 percentage points. Similarly, an annual increase in real
output of 2.5% was associated with a one-year increase in the unemployment rate of 0.4
percentage points.
Looking Ahead
Knowing what rate of growth is needed to reduce the unemployment rate, or at least
keep it from rising would clearly be useful. That rate, however, tends to vary over time.
There are a number of reasons for that. First of all, growth in the labor force varies due
to changes in population growth, and changing labor force participation rates. Between
1949, and 2000, for example, the civilian labor force grew at an average annual rate of
1.6%. More recently, however that rate has been slightly less. Between 1990 and 2000,
the annual rate of growth of the labor force was 1.1%. That, by itself, would suggest that
growth might not have to be as fast as 3.5% now to accommodate growth in the labor
force.
Even though the growth rate of the labor force can be known with a certain degree
of confidence, predicting productivity growth presents substantial difficulties. Productivity
growth is most often studied in the context of longer run trends, but in the short run there
can be considerable variation in its rate of change. Between 1949 and 2000, output per
hour of labor grew by 2.5% at an annual rate. More recently, this measure grew at an
annual rate of 2.1% between 1990 and 2000, but at a 2.7% rate between 1995 and 2000.
In the second half of the 1990s, productivity growth accelerated.
3 David Altig, Terry Fitzgerald, and Peter Rupert, “Okun’s Law Revisited: Should We Worry
about Low Unemployment?,” Federal Reserve Bank of Cleveland Economic Commentary,
November 27, 2001. Available on the internet at:[www.clev.frb.org/Research/com97/0515.htm].
4 See: CRS Report RL30738, Why has the unemployment rate fallen when inflation is stable?,
by Marc Labonte.

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From a policy perspective, what matters is what the growth rate of productivity will
be in the future. Productivity growth is driven by two factors. One is the rate of increase
in the amount of capital available to each worker, which is in turn a function of the rate of
investment. The other is the rate of technological progress. Technological progress is a
variable that is not easily forecast, not to mention that it is difficult even to measure. Who
can say when the next technical breakthrough that will lead to improving living standards
will happen? Not only that, but even when there is such an innovation who can say what
effect it may have down the road? Even now, the effect of the introduction of personal
computers on the economy is subject to considerable uncertainty.
Past variations in productivity growth are poorly understood. Because of that, there
is little basis on which to make projections of productivity growth short of extrapolating
current trends. But, there is some uncertainty about what the trend rate of productivity
is. Productivity growth accelerated in the second half of the 1990s. That was unusual in
that it happened, not in the initial stages of an economic upswing as might typically have
been the case, but in a mature economic expansion, and led more than a few economists
to suggest that it might be indicative of a durable increase, rather than a short-term cyclical
phenomenon.
As the increased rate of growth in productivity persisted through the end of the most
recent expansion forecasters gradually began to raise their long-term projections of
economic growth. Over the last few years, estimates of the long-term growth rate of
productivity have risen from about 1.5% to about 2.5%. Combined with labor force
growth of about 1%, that yields an economic growth rate of about 3.5% that would be
required to accommodate growth in the labor force and hold the unemployment rate
steady. In the very short run, there may be variations in the unemployment rate due to
factors other than the rate of economic growth. Over longer periods of time, however, it
may take economic growth in excess of 3.5% to achieve substantial reductions in the
unemployment rate.