Asian Economic and Financial Review THE VALIDITY OF OKUN S LAW IN NIGERIA: A DIFFERENCE MODEL APPROACH. Sikiru Jimoh BABALOLA. Jimoh Olakunle SAKA

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1 Asian Economic and Financial Review journal homepage: hp://aessweb.com/journal-deail.php?id=5002 THE VALIDITY OF OKUN S LAW IN NIGERIA: A DIFFERENCE MODEL APPROACH Sikiru Jimoh BABALOLA Lecurer, Deparmen of Economics, Modibbo Adama Universiy of Technology, Yola, Adamawa Sae, Nigeria Jimoh Olakunle SAKA Lecurer, Deparmen of Economics, Lagos Sae Universiy,Ojo, Ojo, Lagos Nigeria Idris Abiodun ADENUGA Lecurer, Deparmen of Economics, Lagos Sae Universiy,Ojo, Ojo, Lagos Nigeria ABSTRACT This paper, empirically, ess he validiy of Okun s law in Nigerian economy from The wo versions of he difference model approach of he Okun s law are used even hough one of hem is frequenly used in he lieraure. We uilize Var-coinegraion mehod and examine he direcion of causaliy using he Var Granger causaliy/block Exgeneiy Wald es. We find ha he race es saisic demonsraes only one coinegraing vecor a 5% level. Boh he Var Granger causaliy/block Exogeneiy Wald es and error correcion model provide exacly he same conclusion of a uni-direcional causaliy from unemploymen rae o real oupu growh. However, Okun s coefficien esimaes carry posiive signs in boh models and are infac conrary o unemploymen oupu relaionship even hough unemploymen rae deermines he real oupu growh in Nigeria bu no vice versa from he causaliy analysis. Therefore a good policy space is needed o creae an enabling environmen for drasic reducion of unemploymen which is a poiner o increasing aggregae demand and oupu growh in Nigeria in he long run. Keywords: Okun s law, Unemploymen, Economic Growh, ECM, Nigeria. JEL Classificaion Codes: C12, C22, E24, J63, O11, O INTRODUCTION Unemploymen is one of he major economic challenges every naion ries o avoid or reduce o he bares minimum. As a maer of fac, rae of unemploymen is one of he indicaors for measuring he performance of any economy in he world. Thus, effors are being made by counries o manage he problem of unemploymen and is spillover effecs. I was in an aemp o ackle such menace ha led Arhur M. Okun in he early 1960s o saisically esablish he relaionship 1598

2 beween change in he unemploymen rae and economic growh. The empirical finding of Okun s work indicaes 3:1 rade-off beween real gross naional produc (GNP) and he unemploymen rae. Specifically, Okun s law posulaes a bi-direcional relaionship beween oupu and he unemploymen rae. Inuiively, more labour is required o produce more oupu and as employmen of labour increases during recovery sage of business cycle, personal income increases which in urn increases he aggregae demand and hence naional oupu. However, during he recessionary sage of business cycle, workers lose heir jobs (i.e., unemploymen rae increases as oupu decreases). A journey hrough he lieraure reveals ha combinaion of Okun s law and Phillips curve provides he heoreical foundaion for deriving he aggregae supply curve. Okun s law also serves as a rule of humb for srucural and sabilizaion policies. Similarly, he coefficien of Okun s law is very useful in forecasing he magniude of macroeconomic variables (Rubcova, 2010). The aim of his paper is o conribue o he exising lieraure using one of he Sub-Saharan African counries (Nigeria) because of is obvious high unemploymen rae. The res of he paper is organized as follows: Secion wo reviews he relaed empirical lieraure while secion hree discusses he heoreical framework and mehodological issues. Secion four presens and discusses he empirical resuls of he sudy. Secion five, which is he las secion, concludes he paper. 2. A REVIEW OF SOME EMPIRICAL LITERATURE The relaionship beween economic growh (real oupu) and rae of unemploymen has generaed large volume of empirical sudies since he pioneer work of Okun (1962). The available lieraure on Okun s law is exensive and for space consrain, some of hese sudies are seleced for review as follows: Meidani and Zabihi (2011) examine he dynamic effec of unemploymen rae on per capia real GDP in Iran over he period 1971 and Using an Auo-Regressive Disribued Lag (ARDL), he sudy finds ha he unemploymen rae has a significan and negaive effec on per capia real GDP in he long-run and shor-run periods. Lal e al. (2010) es he validiy of Okun s law in some seleced Asian counries using ime series annual daa during he period The sudy employs Engle-Granger (1987) coinegraion echnique o esablish he long-run relaionship beween he variables of ineres and error correcion mechanism for shor-run dynamics. Afer he empirical analysis, he resuls of he sudy indicae non-applicabiliy of Okun s law in some Asian counries. Rubcova (2010) esimaes Okun s coefficien for Balic Saes using coinegraion and error correcion model framework. The sudy also uilizes Hodrick-Presco filer which allows he rend o change smoohly and gradually in he course of real business cycles analysis. The resuls of he sudy do no provide evidence in suppor of srong relaionship beween unemploymen and oupu. The sudy, herefore, suggess daa reliabiliy issues and labour marke feaures as reasons for such resuls. 1599

3 Villaverde and Maza (2009) verify he validiy of Okun s law for he Spanish regions over he period The sudy provides evidence in suppor of a negaive relaionship beween unemploymen and oupu for mos of he regions and for he whole counry. The sudy, however, furher reveals differen esimaes of Okun s coefficiens across he regions which could be aribued o regional dispariies in produciviy. Loria and De Jesús (2007) es he robusness of Okun s law in Mexico uilizing quarerly daa beween he 1 s quarer of 1985 and 4 h quarer of Using hree srucural ime series models (Kalman Filer), he sudy esimaes Okun s coefficien o flucuae in he range The sudy also finds robus evidence of bilaeral causaliy beween oupu and unemploymen. Reziis and Apergis (2003) analyse he validiy of Okun s law for cerain regional areas in Greece over he period Using he Hodrick-Presco and band-pass filering echniques, he resuls indicae no much inerregional differences for mos regional areas. The resuls furher indicae ha Okun s relaionship undergoes a srucural change in Afer his break, unemploymen becomes less reacive o oupu changes in all regional areas of sudy. Zagler (2003) analyzes a vecor error correcion model of economic growh and unemploymen in four major European counries, France, Germany, Ialy and Unied Kingdom. The sudy finds he exisence of posiive long-run relaionship beween economic growh and unemploymen; a finding which goes conrary o Okun s law. However, he shor-run dynamics of he wo variables of ineres indicaes agreemen wih Okun s law. The sudy furher reveals ha Okun s coefficien is in agreemen wih previous esimaes for he counries in he sample wih he excepion of Unied Kingdom. On Nigeria, Arewa and Nwakanma (2012) conduc an empirical evaluaion of he relaionship beween oupu and unemploymen using he firs difference and oupu-gap models of Okun s law. The sudy finds no evidence o suppor he validiy of Okun s law in Nigeria. 3. THEORETICAL FRAMEWORK AND THE MODEL 3.1. Theoreical Framework Theoreical viewpoin suppors he exisence of posiive relaionship beween real GDP growh and employmen level. William Phillips proposed higher price level following increasing employmen level. Increasing employmen level ends o increase he GDP growh rae, hus, employmen and GDP growh raes are posiively relaed wih each oher and as such, unemploymen and GDP growh raes will be negaively relaed o each oher. Arhur Okun defined his negaive relaionship beween GDP growh and unemploymen rae and his is he only empirical hypohesis explaining he relaionship beween unemploymen rae and GDP growh. The differen versions of he hypohesis are discussed below: 3.2. Model Specificaion Difference Model RGDPG RGDPG ( UNR UNR ) (1)

4 Gap Model Where: RGDPG RGDPG ( ) 0 1 UNR UNR (2) * * RGDPG = Real Gross Domesic Produc Growh (measured in naural logarihm) * RGDPG = Poenial oupu (measured in naural logarihm) RGDPG = One period lagged Real Gross Domesic Produc Growh (measured in naural logarihm) 1 UNR = Unemploymen rae (measured in percenage) * UNR = Naural/Normal rae of unemploymen (measured in percenage) UNR = One period lagged unemploymen rae (measured in percenage) 1 = Whie noise error erm A priori/theoreical Expecaion: 0 > 0, 1 < 0. The Dynamic Version (3) Where = curren unemploymen rae, = One period lagged unemploymen rae, = Two period lagged unemploymen rae, = One period lagged GDP growh rae, = Two period lagged GDP growh rae Equaion (3) is ransformable o The Producion Funcion (4) (5) Where = oupu, = capial inpu, = uilizaion rae, n = numbers of workers, h= numbers of hours worked, and are oupu elasiciies, and are 1601

5 conribuions of he workers and weekly hours o he oal labour inpu and is he disembodied echnology facor. As a maer of fac, his paper uses he difference model version of Okun s law. The daa used in his sudy are basically ime series of Real Gross Domesic Produc growh rae (RGDPG) and unemploymen rae (UNR) covering he period The daa were basically sourced from Cenral Bank of Nigeria (CBN) Saisical Bullein and Naional Bureau of Saisics from which he RGDP growh rae was compued. RGDP growh rae for 2012 was aken for he 2nd quarer Economeric Issues Uni Roo Tes Generally, macroeconomic ime series daa are sochasically rended, which is a problem ha can be solved by differencing. A number of ess can be used o verify he presence of uni roos in ime series. This presen sudy adops he Augmened Dickey-Fuller (ADF) es for he presence of uni roos in oupu and unemploymen rae variables. Theoreically, he following ADF specificaions are possible: m y y y u (6) 1 i i i i i i 1 m y y y u (7) i i i 1 m y y y u (8) Each of he models is applied depending on he properies of a series. Thus, if a series has no inercep and rend, model (6) is appropriae, while model (7) is more appropriae if a series has inercep wihou rend. Model (8) is applicable if a series has boh inercep and ime rend Coinegraion Tes In he conex of ime series lieraure, coinegraion es is conduced wih a view o deecing common sochasic rends in a se of variables. In oher words, coinegraion is imporan o avoid spurious regression esimaes. In he ligh of his, his sudy adops he coinegraion approach developed by Johansen (1988) and expanded by Johansen and Juselius (1990) Error Correcion Models Afer esing for uni roos and coinegraion, he shor-run dynamics is esablished by specifying he following error correcion models: p y y x ECT p (9) 0 1, i i 2, i i 1 i 1 i

6 q q ' 0 1, i i 2, i i 1 i 1 i 0 (10) x y x ECT u Where y = Real Gross Domesic Produc Growh (measured in naural logarihm) x = Unemploymen rae (measured in percenage) and = Measures (in %) of speed of adjusmen back o long-run equilibrium afer shor-run deviaion. 4. RESULTS AND DISCUSSION Table-1. Saisical Analysis of RGDPG and UNR Mean Median Max Min sd dev Skewness Kurosis J-B prob RGDPG DUNR Source: All compuaions are carried ou using Economeric views Table I above shows he saisical analysis of he daa. Virually all he saisics compued for real GDP growh rae (RGDPG) exceed hose compued for he change in unemploymen rae ( UNR). Mos imporanly, he RGDPG flucuaes more han he UNR over he same period as demonsraed by he sandard deviaion. While boh disribuions are posiively skewed, he degree of peakedness is higher for he RGDPG as shown by he coefficiens of kurosis. The residuals are however no normally disribued based on he saisic provided. Table-2. Augmened Dickey Fuller (ADF) Tes for Saionariy Variable ADF saisic Prob Order of Inegraion Decision RGDPG I(0) Saionary DUNR I(0) Saionary Firs an informal es of saionariy was carried ou using he muliple graphical mehod. There seems o be a clearly idenified slow decay for he RGDP variable han he UNR. Due o he doub cas on his mehod, we carried ou a formal es for saionariy using he ADF. As shown in able 2, he variables RGDPG and DUNR are saionary in levels based on he probabiliy values approximaely given by The exisence of his saionariy may faciliae he long run equilibrium relaionship. Table-3. Lag Lengh Selecion Lag 0 Log L LR NA FPE AIC SC 10.83* HQ * * * 1603

7 In an aemp o carry ou he vecor auoregression esimaion, he choice of lag lengh is paramoun. We herefore uilized various lag lengh selecion crieria: Sequenial modified LR es saisic wih each es a 5%, he Final predicion error (FPE), Akaike informaion crierion (AIC), Schwarz informaion crierion (SC) and he Hannan-Quinn informaion crierion (HQ). However each of hese has differen penaly facors. Some sudies have chosen each of hese crieria on differen occasions. For insance, some have used he LR and FPE crieria. The AIC is known for long lag lengh while he SC for shor. We adoped he HQ crierion on he ground ha is opimal lag lengh is in- beween he AIC and SC based on frequen pracical experience. Therefore he opimal lag lengh for HQ = 2 which also equal ha of he SC. I should be noed ha a higher lag lengh resuls in a loss of observaion in he series. Table-4. Var Residual Serial Correlaion LM Tes Lags LM sa Prob The LM es of residual serial correlaion shows no auocorrelaion among he successive residuals a any of he seleced lags as shown by all probabiliy values being greaer han 5% level. Table-5. Vecor Auorgression Esimaes (VAR), lag lengh = 2 RGDPG DUNR RGDPG(-1) RGDP(-2) DUNR(-1) DUNR(-2) C R 2 = 0.49 R 2 = 0.02 The VAR esimae shows only he second lag of RGDPG influences he curren RGDPG negaively. However, he coefficien of he second lag of UNR is highes among he explanaory variables in he RGDPG equaion. Hence changes in unemploymen rae in he las wo periods impaced more on he economic growh rae more han he immediae pas changes in unemploymen rae. For he UNR equaion, impacs of 1 uni change in RGDPG boh a firs and second lags on he unemploymen rae changes were negligible over he periods. By implicaion, one and wo periods ago of increase oupu creaed a very small decrease in changes in unemploymen rae. 1604

8 Table-6. Unresriced Coinegraion Rank Tes (Trace and Maximum Eigen value) Hypohesized no of coingeraion Eigen value Trace sa/5% criical value Maximum-Eigen value/5% criical value None / /19.39 A mos / /12.52 Adjusmen Coefficien Sd error in parenhesis D(RGDPG) -0.85(0.24) D(DUNR) -0.23(0.13) The unresriced coinegraion rank es of able 6 shows ha here is only one coinegraing vecor a 5% for he race es saisic, wo coinegraing vecors for he maximum-eigen value es bu only a 10%. Given his, here is hen a long run relaionship beween he real GDP growh rae and unemploymen rae implying ha changes in unemploymen rae are some of he deermining facors for growh. Unemploymen affecs growh hrough several mechanisms in he macroeconomic sysems. One of such is he aggregae demand which may be linked wih changes in unemploymen rae. A wide spread change in unemploymen would have some appreciable impac on growh in aggregae demand; he same may go from growh o unemploymen. The adjusmen coefficiens for boh RGDPG and UNR a firs and second differences are nonposiive. Changes in unemploymen rae as facor for growh are suppored by he Var Granger Causaliy/Block Exogeneiy Wald Tess showing ha changes in unemploymen Granger causes RGDP growh bu no he reverse. Hence a uni-direcional causaliy runs from change in unemploymen o RGDP growh across he periods. Table 7 shows he resuls of causaliy es. Table-7. Var Granger Causaliy/Block Exogeneiy Wald Tess Dep var: Chi-Sq Df Prob RGDPG/DUNR DUNR/ RGDPG 8.15/ /0.96 ALL 8.15/ /0.96 Resuls of Vecor Error Correcion Mechanism (VECM) Here, we specify he error correcion model esimaes as follows for boh he RGDPG and UNR The shor run equaions are derived accordingly from he ECM for boh he RGDPG and UNR. We carry ou a comparaive analysis beween he wo shor run equaions even hough he UNR equaion is mos frequenly adoped. 1605

9 The RGDPG equaion shows a uni-direcional causaliy beween unemploymen rae and he real GDP growh as demonsraed by he significan coefficien of he second lag of changes in unemploymen rae. Whereas he UNR equaion shows ha no causaliy runs from real GDP growh a any lag o unemploymen rae due basically o he insignifican naure of he real GDP growh coefficien. I is herefore obvious ha causaliy only runs from unemploymen rae o real GDP growh during he period. This resul is exacly in conformiy wih he Var Granger causaliy /Block Exogeneiy Wald es earlier carried ou. The error correcion coefficien indicaes how quickly equilibrium is resored. Expecedly, i is negaive and saisically significan for he RGDPG model and shows ha abou 85% deviaion from equilibrium posiion is correced for per period. Boh oupu growh and unemploymen have a shor run negaive relaionship as indicaed by he coefficien which is he shor run variaion in RGDPG due o variaion in UNR. The UNR model shows ha he shor run coefficien is and he error correcion erm is implying ha he UNR adjuss slower han RGDPG. Table-8. Ordinary leas Squares (OLS) Dep. Var: RGDPG Dep Var: UNR Var C Cefficien 4.66 Prob 0.00 Var C Coeff 0.09 Prob 0.87 DUNR(-1) RGDPG R 2 : 0.05, Prob(F) = 0.21 R 2 : 0.07, Prob (F) = 0.13 Inerpreing he RGDPG equaion, he coefficien of changes UNR lagged by one period is posiive (0.54). This implies ha a 1% poin increase in unemploymen rae resuls in abou 0.54 uni poin increase in growh which acually invalidaes Okun s law in Nigeria. Furhermore, he Okun s coefficien remains saisically insignifican. The coefficien of deerminaion is exremely low and his poins o he fac ha changes unemploymen rae variable canno significanly conribue o he growh. Now wih UNR as he dependen variable, he inerpreaion sill holds as above. I follows hen ha growh paern oo is no significanly explaining he unemploymen paern in Nigeria. Clearly he esimaions in boh cases are a variance wih he Okun s law of a negaive relaionship beween growh and unemploymen even hough he causaliy es showed a unidirecional relaionship. Thus Okun s law does no hold for Nigeria. This finding is in conformiy wih ha of similar sudies by Lal e al. (2010) and Arewa and Nwakanma (2012) on some seleced Asian counries and Nigeria respecively. The finding, however, goes conrary o ha of Meidani and Zabihi (2011) in heir sudy on Iran. 5. CONCLUSION, POLICY IMPLICATIONS AND SUGGESTIONS The focus in his paper is o es he validiy of Okun s law in respec o Nigeria using he difference model approach. Boh he long-run and shor-run relaionships are examined wih he use of empirical daa covering he period 33 years. Our analysis indicaes a long-run relaionship beween real gross domesic produc growh rae and unemploymen rae. The Okun s coefficiens 1606

10 are compued for he wo equaions under he difference model approach for comparison purpose. We found ha he coefficien of unemploymen rae as an independen variable was posiive and also posiive for real GDP growh as an independen variable. These findings are infac conrary o Okun s law of unemploymen oupu relaionship. If posiive growh could lead o unemploymen rae, hen i follows ha resources are subsanially being chanelled owards unproducive aciviies and o a large exen is an apparen mismach in he sysem. I would herefore be a good policy space o direc resources coninuously from unproducive secors o producive ones including creaing an enabling environmen for drasic reducion of unemploymen rae, which is a poiner o increasing aggregae demand and oupu growh in he long run. REFERENCES Arewa, A. and P.C. Nwakanma, Poenial-real gdp and growh process of nigerian economy: An empirical re-evaluaion of okun s law. European Scienific Journal, 8(9): Johansen, S., Saisical analysis of co-inegraion vecors. Journal of Economic Dynamics and Conrol 12(2-3): Available from hp://dx.doi.org/ / (88) Johansen, S. and K. Juselius, Maximum likelihood esimaion and inference on coinegraion wih applicaions for he demand for money. Oxford Bullein of Economics and Saisics, 52(2): Lal, I., D. Sulaiman, M.A. Jalil and A. Hussain, Tes of okun s law in some asian counries:coinegraion approach. European Journal of Scienific Research, 40(1): Available from hp:// Loria, E. and L. De Jesús, The robusness of okun s law: Evidence from mexico (a quarerly validaion, ). Meidani, N.A.A. and M. Zabihi, The dynamic effec of unemploymen rae on per capia real gdp in iran. Inernaional journal of Economics and Finance, 3(5): Available from hp:// Reziis, A. and N. Apergis, An examinaion of okun s law: Evidence from regional areas in Greece. Applied Economics, 35(10): Available from hp:// Rubcova, A., Okun s law: Evidence from he balic saes. SSE Riga Suden Research Papers 2010:9(126), ISSN , ISBN Villaverde, J. and A. Maza, The robusness of okun s law in spain, :Regional evidence. Journal of Policy Modelling 31(2): Available from hp:// Zagler, M., A vecor error correcion model of economic growh and unemploymen in major european counries and an analysis of okun s law. Applied Economerics 1607

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