A Vector Correction Model of Economic Growth and Unemployment in Major European Countries and an Analysis of Okun's Law

Abstract

This paper analyzes a vector error correction model of economic growth and unemployment in four major European economies, France, Germany, Italy, and the UK. We find that unemployment and economic growth are cointegrated, and driven be the same autoregressive unit root present in most endogenous growth models. In the long run, economic growth and unemployment are positively correlated, as suggested by recent economic theories on endogenous growth and unemployment. In the short-run, an increase in the equilibrium unemployment rate is related to a decline in economic growth rates. The short-run dynamics of economic growth and unemployment therefore remain consistent with Okun's law. Okun's coefficient is in line with previous estimates for all countries except for the UK, whose labor market appears much more flexible in accommodating adverse transitory shocks than continental labor markets.

Keywords: Endogenous Growth, Equilibrium, Unemployment, Cointegration, Vector Error Correction Models, Okun's Law

JEL Classification: J63, O41, O52, C32