Okun's Law and Potential Output

Figure 1: Unemployment Rate 
Time-varying coefficients model, annual change 
Sources: ABS; Authors’ calculations 
Real unit labour costs have had a clear and important influence on the Australian 
unemployment rate, with a coefficient that is highly statistically significant in both 
models. Long-run effects change over time due to interaction with the coefficient 
on the lagged dependent variable. As a guide, the largest response followed the 
12 per cent (0.112 log points) increase in real unit labour costs over the five 
quarters to 1975:Q1. We estimate that this increase, if sustained, would have raised 
the unemployment rate by 1.1 percentage points in addition to its effects on the 
output gap. Since the late 1980s, real unit labour costs have been more stable and 
hence less important for explaining changes in unemployment. 
Inclusion of real unit labour costs does not greatly affect other results. Without it, 
our residuals would be even more skewed – because some of the largest increases 
in unemployment, in 1975 and 1982, are partly explained by large increases in real 
unit labour costs. We discuss skewness in Section 6.1. Our estimate of the variance 
of changes in potential output growth would be slightly smaller, giving rise to a 
slightly flatter decline in potential over the past two decades, with a final 
(2015:Q1) estimate of 3.1 per cent. And, as mentioned in Section 5, recent 
forecasts would be slightly more accurate. 
0
2
0
2
1964
1974
1984
1994
2004
2014
-2
0
2
-2
0
2
Actual
%
Change in unemployment
ppt
%
ppt
Contributions
Okun’s law
predicted values
Lagged unemployment
Residual
Real unit labour costs
Output gap

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