A sustainable rate of real GDP growth is one of the best ways to promote the rise of living standards. From a neoclassical point of view the underlying factors that affect economic growth are saving, population growth and technological progress. UnemploymEconomic growth, Natural rate of unemployment, Okuns's law

Dedu Vasile

Dumitrescu Bogdan Andrei

Enciu Adrian

English

Research Papers in Economics

317 
 
THE CORRELATION BETWEEN UNEMPLOYMENT AND REAL GDP GROWTH. A 
STUDY CASE ON ROMANIA 
 
Dumitrescu Bogdan Andrei 
The Academy of Economic Studies Faculty of Finance, Insurance, Banking and Stock Exchange 
6, Romana Square, Bucharest, Romania E-mail: bdumitrescu@hotmail.com 0722.268.342 
Dedu Vasile 
The Academy of Economic Studies Faculty of Finance, Insurance, Banking and Stock Exchange 
6, Romana Square, Bucharest, Romania E-mail: vdedu03@yahoo.com 0722.600.863 
Enciu Adrian 
The Academy of Economic Studies Faculty of Finance, Insurance, Banking and Stock Exchange  
6, Romana Square, Bucharest, Romania E-mail: adrianenciu@yahoo.com 0744.676.092 
 
A sustainable rate of real GDP growth is one of the best ways to promote the rise of living standards. From 
a neoclassical point of view the underlying factors that affect economic growth are saving, population 
growth  and  technological  progress.  Unemployment  is  also  very  important  for  obtaining  a  sustainable 
economic  growth.  If  unemployment  is  below  its  natural  level,  economic  growth  will  generate  higher 
inflation .This paper emphasizes the link between real GDP growth and unemployment, as described by 
Okun’s  law.  The  empirical  analysis  shows  that  a  rise  of  one  percentage  point  of  unemployment  is 
associated with a decline of roughly half percentage point of real GDP growth. 
 
Keywords: economic growth, natural rate of unemployment, Okun’s law 
JEL Classification: F43 
 
I. Introduction 
Economic growth is one of the key macroeconomic variables and is closely monitored by both 
policy makers and the public. Alongside with inflation, the exchange rate and the unemployment 
rate it helps to create an overview picture of a country’s economy and its level of development. 
For the measurement of the economic growth, usually data regarding gross domestic product are 
used, because it quantifies the total income of everyone in the economy. Thus, differences in the 
growth rate of real GDP can explain the observed differences in the living standards across 
countries. It must be stated that even small differential in the growth rates can create important 
gaps between countries determined by the compounding effect. For example the average annual 
growth rate of the Unites States over the 1870-1990 periods was about 1.75 percents. If this rate 
would have been smaller by 1 percentage point the United States would have been as developed 
as Mexico and Hungary.  In contrast if the growth rate would have been 1 percentage point 
higher, real GDP per capita would have been 3 times higher the current level. 
 
II. Underlying factors of real GDP growth 
From a neoclassical point of view the underlying factors that affect economic growth are saving, 
population growth and technological process. 
The Solow model shows that the saving rate is one of the most important factors of the steady-
state capital stock for an economy. The steady-state capital stock describes a point at which the 
amount of investments equals the amount of depreciation. At this level capital stock and output 
are constant over time. This point is important because it can be seen as long run equilibrium for 
the economy: no matter the level of capital that characterizes an economy at some moment in 
time; in the end the capital stock will reach its equilibrium value. This observation can explain 
large rates of economic growth observed in Japan and Germany after the Second World War. 
Even though, important parts of the capital stock were destroyed, if the saving rate – the fraction 
of output devoted to saving and investment- remain unchanged the economy will experience a 
period of high growth until it will reach the steady state. The output grows because more capital 318 
 
is  added  than  lost  through  depreciation.  Thus,  even  if  GDP  initially  falls  as  a  result  of  the 
destruction of the capital stock, the economy will experience higher growth rates afterwards. 
The saving rate is crucial for the determination of a country’s steady-state capital stock. If the 
saving rate is high the country will have an important capital stock and as a consequence larger 
output. If, by contrast, the saving rate is low, the accumulation of capital will be a slow process 
and the output will be low. This finding of the Solow growth model suggests that persistent 
budget deficits are detrimental for economic growth in the long time because they reduce national 
saving and lower output. 
As a conclusion, a higher saving rate induces a larger output on the long run. But there is only 
one value for the steady state capital stock that also maximizes consumption. This point is called 
The Golden Rule level of capital. The policy makers find this point as the most desirable but 
reaching here is a tradeoff of consumption of the present generation versus consumption of the 
future generation. An economy that already has a steady state, different than the one requested by 
the Golden Rule and disposes of too little capital has to increase its rate of saving and accept a 
period of lower consumption in order to increase its capital stock and maximize consumption on 
the long term. 
Another underlying factor of real GDP per capita is population growth. It has been observed that 
there is a negative correlation between the rate of population growth and the level of income but 
this correlation not imply also causation. Population growth shed light of raising capital and total 
output at the steady-state even though capital per worker and output per worker are constant. If 
the population growth rate increases output per worker will fall and the steady state level of 
capital per worker will be reduced. Thus, in order to obtain or to maintain high standards of 
living, policy makers closely observe the population growth rate and interfere sometimes if the 
growth  rate  is  considered  unsustainable.  Is  has  been  observed  that,  in  the  most  cases,  low 
population growth is associated with high levels of income. But there can be others factors that 
link low population growth to high levels of income: the degree of women employed the level of 
education, the availability of birth-control methods. 
The last underlying factor that affects real GDP growth from the neoclassical point of view is 
technological progress. In fact, this factor is considered as essential in explaining persistently 
rising living standards. Technological progress is introduced in the model as a factor causing the 
efficiency of labor to rise by a fixed percent. Now, in the steady state the change in the capital 
stock equals investment minus break-even investment (depreciation, population growth and the 
growth  rate  induce  by  technological  process).Thus,  a  rise  in  saving  will  cause  a  rise  in  the 
economic growth until the steady state is reached. After this point is reached, the growth rate 
depends only of the rate of technological progress.  
The rate of unemployment is another key macroeconomic variable because it shows how well an 
economy is using its resources. Unemployment cannot be zero even if the economy it’s operating 
at full capacity because of the frictional and structural unemployment. Frictional unemployment 
is determined by the time spent to match workers and jobs. This period can vary quite a lot 
because of imperfect information regarding job vacancies, relative geographic immobility of the 
workers and wage rigidity. Sectoral shifts appear quite often in an economy, because the demand 
for goods shifts over time. Thus, it will take time for the workers to adjust to this sectoral shift. 
The natural rate of unemployment is defined as the rate of unemployment at which the economy 
is operating at its full capacity. Thus, there is some unemployment but it is due to frictional 
unemployment. This natural rate of unemployment is sometimes associated with NAIRU- Non 
Accelerating Inflation Rate on Unemployment. If the actual unemployment falls below NAIRU, 
inflation will rise quickly as employers will pay higher wages to attract the workers. If the actual 
unemployment is higher than NAIRU inflation will be lower because  salaries will be lower. 
Although, according to Trifan (2007) the output gap seemed to have a relative small impact over 
the inflation in Romania. 319 
 
The GDP obtained when the economy is operating at full capacity is called natural or potential 
GDP. If the GDP is above its natural level, the output gap will be positive and the economy will 
experience inflationary pressures. The only way for GDP to rise without a higher inflation is 
either a larger capital stock or an improvement of the technological process which will determine 
an upward shift of the production function. The potential GDP is not observable and in order to 
calculate it we must determine the long term trend of real GDP. This can be done for example by 
using a Hodrick-Prescott filter. 
The  correlation  between  unemployment  and  real  GDP  growth  should  be  a  negative  one. 
Intuitively,  employed  workers  produce  goods  and  services  and  unemployed  workers  do  not. 
Arthur  Okun  (1962)  was the first  economist  who  studied  the  empirical relationship  between 
unemployment and economic growth. He started his study with a scatterplot, using data on the 
United States, of the change in the unemployment rate on the horizontal axis and the percentage 
change in the real GDP on the vertical axis. The graph showed a negative correlation; thus 
increases in unemployment tend to be associated with lower than normal growth in real GDP. 
The initial form of the Okun’s law can be written as: 
* * * / ) ( ) ( Y Y Y U U - = - w (1), 
where U is the unemployment rate, Y is real GDP and an asterisk represents potential or natural 
rate  levels  of  the  variables.  The  above  equation  states  that  for  every  percentage  point  the 
unemployment is below the natural rate, GDP is  w % above potential GDP. Okun empirically 
demonstrated that for the United States  w  is approximately 2. Thus, GDP falls by 2 percent 
relating to its potential if the unemployment rate falls by 1 percentage point. 
In order to empirically estimate Okun’s law, giving the fact that 
* U  and 
* Y  are difficult to 
estimate we will use a reduced form of the previous equation. 
To derive the growth rate version, we first expand equation 1: 
* * * * / / Y Y Y Y U U - = -w w (2) 
Now, we differentiate equation 2 with respect to all variables. In order to simplify our analysis 
we will consider 
* Y as a constant, stating the potential GDP is not changing on the short term. 
Thus:  
* * * * / / Y dY Y dY dU dU - - -w w (3) 
Also, we shall assume that the change of the natural rate of unemployment 
* dU =0. Using this 
assumption and rearranging we obtain: 
* * * / / Y dY dU Y dY + - = w (4) 
The natural real GDP growth rate is usually close to the real growth rate. Therefore we can 
approximate  Y dY /
*  with Y dY / . This modification can be invalidated on the short run but on 
the long run it is consistent. Thus:   
* * / / Y dY dU Y dY + - = w (5). 
This equation states that the real GDP growth rate is equal to the potential GDP growth rate less 
the product of Okun’s law coefficient and the change in unemployment rate. Using ordinary least 
squares Okun has obtained  2 @ w    and 3 /
* * @ Y dY . Thus potential GDP growth rate is about 3 
percentage points while a rise in unemployment by 1 percentage point will lower real GDP 
growth rate by 2 percentage points.    
 
III. Testing the validity of Okun’s law for Romania 
In order to empirically test Okun’s law for Romania, we have used data for real GDP growth and 
unemployment in the period 2000Q1-2008Q4. The source of the data is The National Institute of 
Statistics,  the  frequency  is  quarterly  and  all  the  series  have  been  seasonally  adjusted  using 
TramoSeats. 320 
 
The first step in analyzing Okun’s law is to plot the data in a standard data plot:  
 
 Graph 1: Scatter plot real GDP growth versus growth of unemployment  
 
The graph suggests that higher values of economic growth can be associated with lower values of 
unemployment growth rate. Also, a downward trend can be identified. 
The second step of the analysis is to create a graph using historical values for real GDP and the 
actual rate of unemployment 
 
 Graph 2: Real GDP vs. unemployment  
 
It is obvious that, during this period of high growth, unemployment has fallen dramatically. 
In order to test the relationship between the GDP growth and unemployment growth rate a series 
of preliminary tests were made in order to select the best regression model. First step was to test 
if the variables are stationary by running ADF and PP tests. The results are shown in the table 
below: 
 
Table  1:    Stationary  tests  for  GDP  growth  rate  (dy/y)  and  unemployment  growth  rate 
(du/u) 
Variable   Test   t-statistic  p-value 
dy/y 
ADF   -3.896084  0.0059 
PP  -4.816665  0.0005 
du/u 
ADF  -5.732910  0.0001 
PP  -2.711391  0.0084 
 
Scatter plot dY/Y vs dU/U
0
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09
0.1
0.11
-0.06 -0.05 -0.04 -0.03 -0.02 -0.01 0 0.01 0.02 0.03 0.04
du/u
d
y
/
y
dU/U
Linear (dU/U)
Real GDP vs unemployment
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
10.00%
11.00%
12.00%
13.00%
14.00%
15.00%
16.00%
17.00%
18.00%
19.00%
20.00%
2000 2001 2002 2003 2004 2005 2006 2007 2008
0
3000
6000
9000
12000
15000
18000
21000
24000
27000
30000
33000
36000
Unemployment
GDP real
Log. (Unemployment)321 
 
Both tests confirmed that the variables are stationary in level. Further it was observed that for the 
dependent variable (DY/Y) the partial autocorrelation function showed a dependence in the first 
two lags; as a consequence for better results we included in the regression the first two AR terms. 
After running several regression equations which included  different lags for the unemployment 
growth rate it was choose the one which consider du/u (-2) based on statistically significance 
criterion. Therefore the equation found to describe the best the relationship between the two 
variable on significance and information criteria was: 
e b b b + - + + + = ) 2 ( / ) 2 ( ) 1 ( / 3 2 1 u du ar ar c y dy  
 
Table 2: The regression results 
Dependent Variable: dy/y 
Method: Least Squares 
Sample (adjusted): 2002Q1 2008Q4 
Included observations: 28 after adjustments 
Convergence achieved after 6 iterations 
         
Variable  Coefficient  Std. Error  t-Statistic  Prob.   
         
C  0.057634  0.004384  13.14642  0.0000 
du/u(-2)  -0.492784  0.215824  -2.283264  0.0316 
AR(1)  1.002398  0.192709  5.201616  0.0000 
AR(2)  -0.734719  0.201197  -3.651743  0.0013 
         
R-squared  0.467900     Mean dependent var  0.063236 
Adjusted R-squared  0.401388     S.D. dependent var  0.019665 
S.E. of regression  0.015215     Akaike info criterion  -5.401504 
Sum squared resid  0.005556     Schwarz criterion  -5.211189 
Log likelihood  79.62106     F-statistic  7.034777 
Durbin-Watson stat  2.053652     Prob(F-statistic)  0.001480 
 
The coefficient of dU is around -0.49 and is statistically significant. A rise by one percentage 
point of unemployment will reduce real GDP growth by 0.49 percentage points with a delay of 2 
lags. The intercept can be interpreted as potential GDP growth; so the level of economic growth 
which will not generate inflation is below 5.76 percentage points. Also we can observe a high 
value for R-squared which means that the explanatory variables describe well the variation in 
economic  growth.  The  Durbin-Watson  statistic  is  around  2  which  means  that  there  is  no 
autocorrelation  in  the  residuals.  The  correlogram  of  residuals  confirmed  the  absence  of 
autocorrelation while the White test showed that the errors are homoskedastic  with a p-value of 
96%. 
 
IV. Conclusions 
The correlation between real GDP growth and unemployment is very important for policy makers 
in order to obtain a sustainable rise in living standards. If GDP growth rate is below its natural 
rate it is indicated to promote employment because this rise in total income will note generate 
inflationary pressures. In contrast, if the GDP growth is above its natural level, policy makers 
will decide not to intensively promote the creation of new jobs in order to obtain a sustainable 
growth rate which will not generate inflation. 
The slope of unemployment in Okun’s law in around -0.5 and potential GDP growth is around 
5.7 percentage points and the variables are negatively correlated as predicted by the theory. These 
values are particularly important for policy makers in order to obtain an optimal relation between 322 
 
unemployment and real GDP growth. In the previous years, economic growth in Romania was 
above potential which has generated inflationary pressures.  
 
References 
1. Barro Robert, Sala-i-Martin Xavier (1995), Economic growth, MIT Press Cambridge, London 
2. Dornbusch Rudiger, Fischer Stanley (2007), Macroeconomie, Editura Economica, Bucuresti 
3. Mankiw, Gregory (2004), Macroeconomics, Worth Publishers, New York 
4. Okun, Arthur (1983), Economics for Policy making, MIT Press Cambridge, London 
5. Solow, Robert (2007), The last 50 years in growth theory and the next 10, Oxford Review of 
Economic Policy 23 
6. Trifan, Alina (2007), Inflatia prin preturi si prin salarii, Economie Teoretica si Aplicata pag 
269-276 
7. www.insse.ro-National Institute for Statistics Web Site 

Economics for Policy making,

Inflatia prin preturi si prin salarii, Economie Teoretica si Aplicata pag

Sala-i-Martin Xavier

The last 50 years in growth theory and the next 10,

THE CORRELATION BETWEEN UNEMPOYMENT AND REAL GDP GROWTH.A STUDY CASE ON ROMANIA

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THE CORRELATION BETWEEN UNEMPOYMENT AND REAL GDP GROWTH.A STUDY CASE ON ROMANIA

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