A Macroeconomic Theory of Optimal Unemployment Insurance
54 Pages Posted: 21 Dec 2014 Last revised: 26 Feb 2015
Date Written: February 25, 2015
We develop a theory of optimal unemployment insurance (UI) that accounts for workers' job-search behavior and firms' hiring behavior. The optimal replacement rate of UI is the conventional Baily -Chetty  rate, which solves the trade-off between insurance and job-search incentives, plus a correction term, which is positive when UI brings the labor market tightness closer to efficiency. For instance, when tightness is inefficiently low, optimal UI is more generous than the Baily-Chetty rate if UI raises tightness and less generous if UI lowers tightness. We propose empirical criteria to determine whether tightness is inefficiently high or low and whether UI raises or lowers tightness. The theory has implications for the cyclicality of optimal UI.
Keywords: unemployment insurance, labor market tightness, matching frictions, business cycles
JEL Classification: E24, E32, H21
Suggested Citation: Suggested Citation