Unemployment, Borrowing Constraints and Stabilization Policies

In this paper, we develop a tractable incomplete-market model with unemployment and borrowing constraints. We analyze the effects of ?scal and unemployment insurance policies in reaction to a large economic downturn. Policy instruments are government spending and the unemployment replacement rate. First, our incomplete-market model magnifies ?uctuations in the unemployment rate after various shocks, compared to a standard complete-market model. Second, in response to a large shock that replicates the effects of a crisis, we find that government spending should increase substantially and that the replacement rate should drop. The sign and size of government interventions are quite different in a model with complete markets. Unemployment and borrowing constraints happen to matter quite a lot in determining the aggregate effects of large shocks, the design of optimized policies in response to these shocks and the corresponding welfare gains/losses.