Thresholds for Employment and Unemployment - a Spatial Analysis of German Regional Labour Markets 1992-2000

depends on the deviation of actual output growth from the threshold level. Each per-
centage point of output growth above (below) the threshold comes along with positive
(negative) employment reaction that is determined by the marginal employment inten-
sity.

An increase of employment is often seen to go hand in hand with a simultaneous de-
crease of unemployment. However, demographic factors and institutional conditions of
the labour market can weaken the relationship. For example, if population growth is
accompanied by a similar rise in the labour force but an underproportional increase of
employment, unemployment will accelerate. Also, structural developments like a rising
female labour force participation rate have to be taken into account. Generally, more
favourable institutional settings on the labour market can attract people from outside the
labour force. Thus, a strong relationship between changes in employment and unem-
ployment is suspended. In particular, the minimum output growth rate needed for a rise
in employment may not be sufficient for a drop in unemployment. The threshold for the
latter is estimated by means of Okun’s law.

According to Okun (1962, 1970), a negative relationship between unemployment and
output fluctuations exists. Due to rigidities like menu costs and efficiency wages, prices
are temporarily fixed. As a consequence, firms tend to adjust output to aggregate de-
mand in the short run. A rise in demand will stimulate production and employment,
thereby lowering the unemployment rate. In particular, unemployment u will fall below
its natural rate u*,

(2.7)   (ut-u*)=δ1(yt-y*),δ1 <0,

if actual output growth is above its long run trend or potential y*, that is driven by total
factor productivity. Extended by a Phillips curve, the equation gives the aggregate sup-
ply curve of the economy. In this setting, u* has to be interpreted as the unemployment
rate that is consistent with an unchanged inflation rate. Also, the sacrifice ratio - the
cumulative output loss arising from a permanent decrease in the inflation rate - can be
assessed, see Cechetti and Rich (1999). The lower the Okun coefficient δ1 in absolute
value, the lower the responsiveness of unemployment to growth and the higher the in-
come loss resulting from a policy of disinflation.

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