Okun's law and the output gap

Potential output Y* is what the economy produces when it is at the natural rate of unemployment. The output gap is the distance of actual output from it. Okun found that the two gaps move together: the further unemployment is above the natural rate, the further output is below potential (CUET 2020). The usual rule of thumb, and the one the exam means by “Okun’s law” unless told otherwise, is that output falls two percent below potential for each point of unemployment above the natural rate.

Take the opening question: u − uₙ = 8 − 6 = 2 points, so output is 2 × 2 = 4% below potential, which is 4% of ₹1,000 billion, ₹40 billion. The answer assumes β = 2, which the question leaves to you to supply.

Define the gap as actual output less potential. Then it is negative in a slump (unemployment above the natural rate) and positive in a boom, when factors of production are over-employed (UGC NET 2025). A positive output gap goes with unemployment below the natural rate, and with inflation rising: this is the link to the Phillips curve.

Gaps also tell you about growth. If output was 10% below potential in one year and 5% below in the next, it grew by more than 5%: output went from 0.90 to 0.95 of potential, a rise of 5.6%, even if potential output did not grow at all, and more if investment and the labour force grew (JNU 2017). Closing a gap needs growth above the growth of potential.

The first tab is the gap form with the IIT JAM 2021 numbers. The second tab fits Okun’s law in its difference form to United States data, one dot a year. Change the years and watch the line move.

Potential output is hard to measure, so the law is often written in changes: the change in the unemployment rate against output growth. Percentage growth in real GDP is proportional to the change in the unemployment rate (JNU 2018), with a negative sign: when growth is strong, unemployment falls.

Both forms say the same thing in different clothes: output and unemployment move in opposite directions (CUET 2020; DSE 2011: a negative relationship between unemployment and real GDP). The name belongs to Arthur Okun (IIT JAM 2022); when a question gives you the relation between the output gap and the unemployment gap, that is Okun’s law (GATE 2024).

On the second tab, the US data for 1992 to 2025 give a line of about Δu = 1.5 − 0.59g with an R² of 0.64: each extra point of growth goes with about 0.6 points less unemployment, and growth of about 2.5% a year holds unemployment steady. But look at the two halves: for 1992 to 2007 the slope is about −0.30; for 2008 to 2025 it is about −0.78. Take out the two pandemic years and it moves again. The coefficient depends on the years and the country, which is why the exam’s “2” is a round number to be supplied by the question and not a constant of nature.

Take the Phillips curve π − πᵉ = −β′(u − uₙ) and substitute Okun’s law to replace the unemployment gap by the output gap. The result is a relation between inflation and output: inflation above what was expected goes with output above potential. That is an upward-sloping short-run aggregate supply curve, written in inflation instead of the price level (GATE 2026). The Phillips curve and the aggregate supply curve are the same idea seen from the labour market and the goods market. Lesson 7 uses that to add expectations.