Optimal Unemployment Insurance Over the Business Cycle
Paper No' CEPDP1078:
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Keywords: Unemployment insurance; business cycle, job rationing, matching frictions
JEL Classification: E24; E32; H21; H23
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This Paper is published under the following series:
CEP Discussion Papers
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This paper characterizes optimal unemployment insurance (UI) over the business cycle using
a model of equilibrium unemployment in which jobs are rationed in recession. It offers a
simple optimal UI formula that can be applied to a broad class of equilibrium unemployment
models. In addition to the usual statistics (risk aversion and micro-elasticity of unemployment
with respect to UI), a macro-elasticity appears in the formula to capture the macroeconomic
impact of UI on unemployment. In a model with job rationing, the formula implies that
optimal UI is countercyclical. This result arises because in recession, jobs are lacking
irrespective of job search. Therefore (1) a higher aggregate search effort cannot reduce
aggregate unemployment much; and (2) individual search effort creates a negative externality
by reducing other jobseekers’ probability of finding a job as in a rat race. Hence the social
benefits of job search are low. In a calibrated model, optimal UI increases significantly in
recession. This quantitative result holds whether the government adjusts the level or duration
of benefits; whether it balances its budget each period or uses deficit spending.