An Application of Bayesian Dynamic Linear Model to Okun’s Law

Abstract

Many authors have used dynamic time series regression models to analyse Okun’s law. This type of models often require first differencing the dependent and independent variables, as well as investigating the maximum lag length required for the model to be efficient. In this paper, we propose a straight-forward time-varying parameter state space model for analyzing Okun’s law. In particular, as a case study, we investigate the validity and stability of Okuns law using a Bayesian Dynamic Linear Model which implicitly describes the time-varying relationship between Gross Domestic Product (GDP) and unemployment rate of a major economy in Africa for three decades. The time-varying parameters of this model are estimated via a modified recursive forward filtering, backward sampling algorithm. We find that Okuns law exhibited structural instability in Nigeria in the period 1970-2011, with the sensitivity of unemployment rate to movements in output growth loosing stability over time, which may have been a contributor to her recent economic decline