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The Shifting Link Between Economic Growth and Jobs

A long-accepted law of economics is undergoing changes, as the unemployment rate has become more responsive to changes in economic output, according to a new research brief released by the American Institute for Economic Research.

It has long been accepted that as the economy grows, the unemployment rate goes down, and vice versa. This is known as “Okun’s Law,” named for Arthur Okun, an American economist.

But it has not been a 1-to-1 relationship. Okun said in 1962 that for the unemployment rate to fall by 1 percentage point — say, from 6 percent to 5 percent — the economy had to grow by about 3 percent.  Conversely, when economic output falls, the unemployment rate would grow at a considerably slower rate. And that largely held true prior to 2005.

But in a new AIER research brief, senior research fellow Polina Vlasenko writes that since 2005, hiring and layoffs have become more responsive to smaller changes in GDP.

After 2005, GDP needed to grow 1.4 percent above the long-term trend to reduce the unemployment rate by 1 percent. And unemployment grew 0.7 percentage points when GDP fell by 1 percent.

“The increased sensitivity of the unemployment rate to GDP means that after 2005, the unemployment rate could be expected to rise much more in recessions than it used to. It also means that when the unemployment rate falls during recoveries, economic growth will be subdued, as we have seen in the past few years,” Vlasenko writes.

Before 2005, when faced with a drop in demand, companies used to reduce employment by about half the size of the drop. But after 2005, it appears companies have reduced employment by 95 percent of the reduction in demand.

“This new behavior of companies implies that it is no longer difficult or time-consuming for them to find suitable employees,” Vlasenko wrote. “The difficulty of finding new employees once prevented companies from laying off people as soon as they saw any slowdown in demand. But since they now appear to lay off people much more readily in an economic slowdown, employers must believe that recruiting new people will not be a problem once the economy starts growing again.”

The full research brief, which is free to read, can be found here.

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