Augmented Okun’s Law: Does Institutional Quality Shape the Unemployment-Growth Relationship? Insights From Developing and Emerging Economies

Abstract

This article examines whether institutional quality influences the responsiveness of unemployment to output fluctuations—an effect commonly described by Okun’s Law—in a panel of 115 developing and emerging countries over the 1985 to 2023 period. We estimate an augmented version of Okun’s Law that incorporates interaction terms between GDP fluctuations and two proxies for institutional quality: the Worldwide Governance Indicators and the Economic Freedom Index. Using the System-GMM estimator, we address potential endogeneity in both institutional variables and the output gap. Our findings confirm the overall validity of Okun’s Law for the sample, with youth unemployment displaying significantly greater sensitivity to output changes than total unemployment. Importantly, although institutional quality does not exert a direct impact on unemployment, it notably amplifies its responsiveness to economic fluctuations. The Okun coefficient is larger in countries with stronger institutions, particularly in areas related to governance effectiveness and economic freedom. This institutional effect is robust across alternative specifications and consistently stronger for youth unemployment, underscoring the heightened vulnerability of young workers. These results highlight the critical role of institutional reform in enhancing labor market resilience and underscore the need for sound governance to effectively reduce unemployment—especially among youth—and move toward full employment.

Jel classification: C33, J08, O43