Optimal Unemployment Insurance Over the Business Cycle
London School of Economics
London School of Economics & Political Science (LSE) - Department of Economics
University of California, Berkeley - Department of Economics; National Bureau of Economic Research (NBER)
CEPR Discussion Paper No. DP8132
This paper analyzes optimal unemployment insurance over the business cycle in a search model in which unemployment stems from matching frictions (in booms) and job rationing (in recessions). Job rationing during recessions introduces two novel effects ignored in previous studies of optimal unemployment insurance. First, job-search efforts have little effect on aggregate unemployment because the number of jobs available is limited, independently of matching frictions. Second, while job-search efforts increase the individual probability of finding a job, they create a negative externality by reducing other jobseekers' probability of finding one of the few available jobs. Both effects are captured by the positive and countercyclical wedge between micro-elasticity and macro-elasticity of unemployment with respect to net rewards from work. We derive a simple optimal unemployment insurance formula expressed in terms of those two elasticities and risk aversion. The formula coincides with the classical Baily-Chetty formula only when unemployment is low, and macro- and micro-elasticity are (almost) equal. The formula implies that the generosity of unemployment insurance should be countercyclical. We illustrate this result by simulating the optimal unemployment insurance over the business cycle in a dynamic stochastic general equilibrium model calibrated with US data.
Number of Pages in PDF File: 72
Keywords: Business Cycle, Unemployment insurance
JEL Classification: E24, E32, H21, H23working papers series
Date posted: December 6, 2010
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