RDP 2015-14: Okun's Law and Potential Output 7. Directions for Future Research

Our conclusions are stated in the introduction and we do not repeat them. But two possible extensions are worth noting.

Okun's law is a reduced form that does not distinguish between shocks to output arising from demand and those arising from supply. It is possible that the correlations arising from different underlying shocks would differ. The stability of the short-term responses shown in Figure 4 suggests either that responses to different kinds of shocks are similar or that the constellation of shocks has not changed much over our sample. Nevertheless, a deeper understanding of the structure would be interesting. In particular, our model ignores information about other labour market variables, such as productivity, the participation rate and so on. One might hope that taking this information into account would improve estimates of potential output and forecasts of unemployment. The forecast comparisons in Section 5 suggest that this extra information has been difficult to usefully apply. However, that may reflect the simplifications that are often used in ‘structural’ estimates. We suspect multivariate estimation with time-varying parameters would improve performance.

Estimation of our models on annual data provided estimates that forecast surprisingly well out of sample. This partly involved estimates of potential output growth in the 1990s that were relatively low, with unbiased forecasts. We suspect that longer lag structures may have helped in this, though we were unable to capture those with quarterly data. Again further exploration here might be fruitful.