Gross domestic product (GDP) measures the total value of all goods and services produced within a country within a given period, generally one year. GDP represents a valuable piece of data for economists, as it serves as a real-world indicator of a country's economic health. For a more theoretical measure of the economy, economists may also consider full employment GDP. This represents the potential value of GDP when every resource, including all labor and materials, are being used at their maximum level of efficiency. Full employment GDP may also be known as potential or capacity GDP.
In the real world, GDP rarely reaches the level of full employment GDP. The difference between these two values is known as the GDP gap. Economists believe that in a free market economy, a GDP gap can only exist in the short run. In the long run, both consumers and businesses will adjust their buying and production habits so that full employment GDP will be realized.
There are several problems with this theory, however. The first is that economists disagree over the definition of full employment. Some argue that this state occurs when the unemployment rate is at zero, while others believe it can be as high as 10 or 15 percent and still be characterized as full employment.
This discrepancy occurs because there are two kinds of unemployment. Frictional unemployment is temporary, and occurs as people are in between jobs and actively searching for a new one. While these people are included in short-term full employment GDP determinations, structural unemployment is ignored. Structural unemployment refers to the percentage of people who won't work regardless of the state of the economy, whether because they choose not to or are physically unable to. Given that some of these people could contribute to the economy and improve economic efficiency, some theorists argue that full employment GDP can never occur unless all people are employed in jobs appropriate for their skill level.
During the 1960s, economist Arthur Okun developed a theory that is used to relate unemployment rate and GDP gap. Okun's law states that every 1 percent increase in the unemployment rate results in a two-percent increase in GDP gap. While other researchers have put forth variations of this theme, Okun's law continues to serve as a widely-used benchmark or rule or thumb for those studying the relationship between employment and changes in GDP.