Can the baseline search and matching model quantitatively explain Okun’s law?

Abstract

Okun’s Law is an empirically observed, negative relationship between changes in an economy’s unemployment rate and its growth rate of output. The baseline search and matching model with stochastic labour productivity fails to match the Okun’s coefficient, because it generates a too low unemployment volatility and a too high correlation between labour productivity and unemployment. The model is capable of matching the coefficient if it is extended with an addition of employment separation shocks plus a high calibrated value of nonmarket activities. This article also shows that changes in the stochastic properties of exogenous shocks could explain changes in the Okun’s coefficient in the Great Moderation (1984–2007).

Keywords:

• equilibrium unemployment
• Okun’s law
• great moderation
• search model

JEL Classification:

• E24
• E32
• J63
• J64

Notes

¹ Data are from Bureau of Economic Analysis and Bureau of Labor Statistics.

² The literature found that starting from around 1984, the economy of the United States became less volatile (Kim and Nelson, 1999; McConnell and Perwz-Quiros, 2000; Stock, 2002). However, the 2008–2009 Great Depression may have brought this to an end. This article, therefore, follows Dornbusch et al. (2013) to define the time period from 1984 to 2007 as the Great Moderation.

³ Barnichon (2010) developed a New-Keynesian style search and matching model to match the correlation between output per hour and unemployment. However, he did not focus on the volatility of unemployment.

⁴ Results on the gap version of Okun’s law will be presented in Section V.

⁵ I follow the literature of Okun’s law to use the first difference to detrend variables. Sensitivity analysis in Section V will show that the results are robust to using HP-filter.

⁶ I am grateful to an anoynmous referee for suggesting this interpretation.