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CEP discussion paper
Consumption and Savings with Unemployment Risk: Implications for Optimal Employment Contracts
Christopher A. Pissarides
August 2002
Paper No' CEPDP0542:
Full Paper (pdf)

JEL Classification: E21;E24;J32;J33

Tags: employment risk; unemployment risk; severance compensation; notice of dismissal

This paper derives optimal employment contracts when workers are risk averse and there are employment and unemployment risks. Without income insurance, consumption rises during employment and falls during unemployment. Optimal employment contracts offer severance compensation to smooth consumption during employment without causing moral hazard. A pre-announced delay in dismissal when the job becomes unproductive provides further insurance but because of moral hazard it does not fully smooth consumption. During the delay consumption falls and the worker searches for another job. No delays in dismissals are optimal if exogenous unemployment compensation is sufficiently generous.