Endogeneity in Okun’s law

ABSTRACT

This article contributes to the literature of Okun’s law by addressing an under-noticed but important problem, i.e. endogeneity. By using annual variation in the international oil price weighted with countries’ average oil net-export GDP ratios as a plausibly exogenous instrumental variable for economic growth, the two-stage least squares estimates indicate that faster real GDP growth is associated with lower overall, male and female unemployment rates, confirming the validity of Okun’s law. According to our benchmark estimate, 1 percentage point increase in economic growth leads to a 0.252 percentage point decrease in civil unemployment rate.

KEYWORDS:

• Okun’s law
• GDP growth
• unemployment rate
• oil price shocks

JEL CLASSIFICATION:

• C2
• E2

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ See Huang and Lin (2008) for a simple theoretical framework for the Okun’s relationship.

² Countries with less than 20 observations on both variables are dropped. However, the results remain quite similar if we do not impose such restriction.

³ Unlike column (4) of Table 1, the Kleibergen-Paap F statistic for population-weighted and GDP-weighted regressions is now $5.894$ and $9.680$, respectively, signifying the issue of weak instrument is likely to be an issue in the weighted 2SLS estimation.

⁴ Because of the 5-year non-overlapping panel data on the countries’ trade-weighted world income growth, the number of observations in the estimation decreases to 207.

Additional information

Funding

The second author greatly acknowledges financial support from the Ministry of Science and Technology (Taiwan, ROC) via grant number MOST 106-2410-H-032-002. Any remaining errors are our own responsibilities.