Okun’s Law, the GDP Multiplier, and the Stimulus
At a time when the press is filled with sometimes confusing economic news, one can use some simple economic concepts in understanding the economic outlook. Although economists frequently construct complex computer models, there are approximations that are useful in explaining the economy. Two fundamental economic concepts—“Okun’s Law,” and the “GDP multiplier” —are useful in examining the current recession and economic outlook.
“Okun’s Law”—actually a statistical relationship-- states that for every one percentage point by which the actual unemployment rate exceeds the natural (or normal) rate of unemployment, there is a negative GDP gap of two percent. Assuming that the normal unemployment rate is 5% (various economists will use differing but similar estimates based on their analyses of the current economy), the recent unemployment rate of 9.4 percent suggests that the economy is operating at a GDP gap of 8.8 percent. Given that GDP is currently $14,089.7 Billion, we appear to have a GDP gap/recession of $1,462 Billion.
Additional spending by consumers, investors, exporters, and the government can provide a stimulus to the economy, acting to close the gap. For example, when the government spends money, the level of economic activity will increase—and the increase will be by more than a factor of 100%. This effect is called the “GDP multiplier”—increases in spending are circular and cause an economic increase greater than the initial spending. For this brief analysis, one could assume that a rough estimate of the current value of the GDP multiplier is 1.5.
The Stimulus Bill provides a boost of $787 Billion to the economy in deficit spending. However, not all of that increased spending will have an immediate effect in 2009, for much of the Stimulus spending doesn’t take effect until 2010 or even later. Assuming that $300 Billion of the Stimulus Bill takes effect this year, followed by an additional $400 Billion in 2010, the initial stimulus to the economy would be $450 Billion followed by an additional $600 Billion, for a total stimulus of $1,050 Billion by the end of 2010—just about enough to offset the current recession if additional government or other spending occurs--as is frequently the case. With a multiplier of 2 the outlook would be somewhat more favorable, but then again it appears that the GDP gap will continue to increase, given that unemployment is still rising. The actual numbers for the GDP gap and ultimate stimulus will probably vary, but the idea is clear: unemployment is associated with a GDP gap, and a government deficit may close some or all of the gap. Therefore, a simple quick calculation suggests that the stimulus may be too small.
The calculations presented are just rough estimates; a thorough econometric analysis considering the interplay of the financial markets with the economy would yield much greater accuracy and precision. However, these relatively rough calculations show how the course of economic activity may play out in the next two years. The relationship works best when there is slack in the economy, as is now the case: at near full employment the multiplier could actually be zero as government stimulus displaces private spending. The application of Okun’s law suggests that the current Spending Bill is having less of an impact than is desirable.
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