What it is:
Okun's gap occurs when a country's actual gross domestic product differs from its predicted gross domestic product when applying Okun's law.
How it works/Example:
Named after economist Arthur Okun, Okun's law states that for every 1% increase in the employment rate, gross domestic product increases 3%.
Let's say the unemployment rate decreases by 2% (that is, employment increases by 2%). According to Okun's law, GDP increase by 6%. If the actual GDP increases by just 5%, then Okun's Gap equals 1% (6% - 5%). Because the actual change is less than the predicted change, we this gap a recessionary gap. If the actual change were higher than the predicted change, we this an inflationary gap.
Okun's law, however, only applies to the U.S. economy and only applies when the unemployment rate is between 3% and 7.5%.
Why it matters:
Okun's law reinforces the notion that a country's output depends on labor. It is also a way to measure the effectiveness of monetary policy. Although the law only applies in the United States, the concept applies in all economies (that is, when more people have jobs, the is stimulated). Accordingly, a 1% change in employment may result in a different degree of increased output in other countries.