IDEAS home Printed from
   My bibliography  Save this paper

Unemployment Insurance and the Business Cycle: What Adjustments are Needed?


  • Jeremy Schwartz


The United States has extended the duration that unemployment insurance (UI) benefits can be received during every recession in the last half century. In the recession of the early 1990s and 2000s Congress extended UI benefits by 27 and 20 weeks respectively, at a cost of $37.1 and $23.4 billion (Nicholson and Needels, 2006). During the current recession benefits have been extended by an unprecedented 76 weeks at a cost to date of more than $140 billion (Department of Labor). While the consumption smoothing benefits of UI are often cited as justifying these expenditures, there are additional costs to these programs as well. For instance, UI is known to discourage search intensity, as well as decrease job creation by putting upward pressure on wages. Despite the large costs of these programs the literature has yet to fully explore whether benefit extensions during economic downturns are appropriate. The proposed paper develops a search model of the U.S. labor market to determine if extending UI during recessions is welfare improving as well as quantifying the optimal UI system during each phase of the business cycle. The model is unique in that it connects two strands of the optimal UI literature. The first deals with the optimal adjustments to UI when job finding rates fall, but does not consider UI’s impact on job creation. The second strand, endogenizes job creation, but does not address how the benefit system should adjust with the business cycle. The model this paper presents allows for both. To evaluate the policy of adjusting UI during recessions I develop a general equilibrium search model similar to that of Pissarides (1990) and applied to the optimal UI literature by Cahuc and Lehmann (2000) and Frederickson and Holmlund (2001). The model allows for unemployed workers and inactive firms to search for productive matches. Workers can influence their probability of finding work by determining their level of job search effort. The level of effort is private information to the worker resulting in a moral hazard problem in the optimal choice of unemployment insurance. In addition, firms and workers negotiate each period to determine the market wage. Since workers fallback position to employment is being unemployed, the generosity of unemployment insurance puts upward pressure on the wage level, which can result in lower job creation. This is a very undesirable result, particularly in recessions when jobs are already scarce. As a result, the optimal UI system not only takes into account the standard moral hazard problem, but also the effect of the UI system on job creation and macro level employment in recessions and expansions. The government determines the optimal UI benefit system contingent on the phase of the business cycle and subject to an expected budget constraint. The model is calibrated to United States data and the optimization is accomplished through a simulation approach. The economy is simulated over a long period of time to determine the government’s utilitarian welfare function. Given a means to determine the value of the utilitarian welfare function numerical gradients can also be calculated in order to use standard numerical optimization techniques. The method is applied to three types of UI benefit systems; one where the only the duration UI benefits can change during the business cycle, one where the duration and the benefit amount can change, and finally one where the UI benefit may change during each month of unemployment. The results of the simulations indicate that: 1. When the government is restricted to solely adjusting the duration of unemployment insurance benefits, a more generous UI system during recessions is optimal. However, the optimal extension is just 1.3 months, smaller than what is typically provided during U.S. recessions. 2. When the government may adjust both the duration of benefits and their amount, whether or not the UI system should become more generous during recessions is less clear. Although it is optimal to provide UI benefits for a longer period of time during economic downturns, about 4.3 months, it is also welfare enhancing to decrease the benefit amount. The lower benefit amount allows wages to fall in recessions, reducing labor costs and encouraging job creation. It is interesting to note that the United States has taken the exact opposite policy action in the most recent recession, which may be exacerbating the current job crisis. 3. When the government may adjust the benefit amount during each month of unemployment, a declining sequence of benefits is welfare maximizing, similar to much of the optimal UI literature. In addition, during recessions the optimal benefits schedule allows for benefits in the first two months of unemployment to be lower than in expansions. This again allows wages to adjust downward. After two months of unemployment, UI benefits are more generous in recessions to provide greater insurance when the risks of long-term unemployment are higher. 4. The greatest increase in welfare comes from adjusting both the benefit level, as well as the duration of benefits. This contrasts with the current U.S. system which typically only adjusts the duration of benefits.

Suggested Citation

  • Jeremy Schwartz, 2012. "Unemployment Insurance and the Business Cycle: What Adjustments are Needed?," EcoMod2012 3674, EcoMod.
  • Handle: RePEc:ekd:002672:3674

    Download full text from publisher

    File URL:
    Download Restriction: no

    Other versions of this item:

    References listed on IDEAS

    1. Marcus Hagedorn & Iourii Manovskii, 2008. "The Cyclical Behavior of Equilibrium Unemployment and Vacancies Revisited," American Economic Review, American Economic Association, vol. 98(4), pages 1692-1706, September.
    2. Meyer, Bruce D, 1990. "Unemployment Insurance and Unemployment Spells," Econometrica, Econometric Society, vol. 58(4), pages 757-782, July.
    3. Holmlund, Bertil, 1998. " Unemployment Insurance in Theory and Practice," Scandinavian Journal of Economics, Wiley Blackwell, vol. 100(1), pages 113-141, March.
    4. Fredriksson, Peter & Holmlund, Bertil, 2001. "Optimal Unemployment Insurance in Search Equilibrium," Journal of Labor Economics, University of Chicago Press, vol. 19(2), pages 370-399, April.
    5. repec:mpr:mprres:5070 is not listed on IDEAS
    6. Christopher A. Pissarides & Barbara Petrongolo, 2001. "Looking into the Black Box: A Survey of the Matching Function," Journal of Economic Literature, American Economic Association, vol. 39(2), pages 390-431, June.
    7. Shavell, Steven & Weiss, Laurence, 1979. "The Optimal Payment of Unemployment Insurance Benefits over Time," Journal of Political Economy, University of Chicago Press, vol. 87(6), pages 1347-1362, December.
    8. Cahuc, Pierre & Lehmann, Etienne, 2000. "Should unemployment benefits decrease with the unemployment spell?," Journal of Public Economics, Elsevier, vol. 77(1), pages 135-153, July.
    9. Edward C. Prescott, 2004. "Why do Americans work so much more than Europeans?," Quarterly Review, Federal Reserve Bank of Minneapolis, vol. 28(Jul), pages 2-13.
    10. Hansen, Gary D & Imrohoroglu, Ayse, 1992. "The Role of Unemployment Insurance in an Economy with Liquidity Constraints and Moral Hazard," Journal of Political Economy, University of Chicago Press, vol. 100(1), pages 118-142, February.
    11. Gary Solon & Robert Barsky & Jonathan A. Parker, 1994. "Measuring the Cyclicality of Real Wages: How Important is Composition Bias?," The Quarterly Journal of Economics, Oxford University Press, vol. 109(1), pages 1-25.
    12. Wang, Cheng & Williamson, Stephen, 1996. "Unemployment insurance with moral hazard in a dynamic economy," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 44(1), pages 1-41, June.
    13. Kiley Michael T., 2003. "How Should Unemployment Benefits Respond to the Business Cycle?," The B.E. Journal of Economic Analysis & Policy, De Gruyter, vol. 3(1), pages 1-22, July.
    14. Raj Chetty, 2006. "A New Method of Estimating Risk Aversion," American Economic Review, American Economic Association, vol. 96(5), pages 1821-1834, December.
    15. Katz, Lawrence F. & Meyer, Bruce D., 1990. "The impact of the potential duration of unemployment benefits on the duration of unemployment," Journal of Public Economics, Elsevier, vol. 41(1), pages 45-72, February.
    16. Gary Solon & Ryan Michaels & Michael W. L. Elsby, 2009. "The Ins and Outs of Cyclical Unemployment," American Economic Journal: Macroeconomics, American Economic Association, vol. 1(1), pages 84-110, January.
    17. Shigeru Fujita & Garey Ramey, 2009. "The Cyclicality Of Separation And Job Finding Rates," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 50(2), pages 415-430, May.
    18. Steven J. Davis & Magnus Henrekson, 2004. "Tax Effects on Work Activity, Industry Mix and Shadow Economy Size: Evidence from Rich-Country Comparisons," NBER Working Papers 10509, National Bureau of Economic Research, Inc.
    19. Sánchez, Juan M., 2008. "Optimal state-contingent unemployment insurance," Economics Letters, Elsevier, vol. 98(3), pages 348-357, March.
    20. Pavoni, Nicola, 2007. "On optimal unemployment compensation," Journal of Monetary Economics, Elsevier, vol. 54(6), pages 1612-1630, September.
    21. Edi Karni, 1999. "Optimal Unemployment Insurance: A Survey," Southern Economic Journal, Southern Economic Association, vol. 66(2), pages 442-465, October.
    22. Dale Mortensen & Eva Nagypal, 2007. "More on Unemployment and Vacancy Fluctuations," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 10(3), pages 327-347, July.
    23. Robert E. Lucas Jr., 2003. "Macroeconomic Priorities," American Economic Review, American Economic Association, vol. 93(1), pages 1-14, March.
    24. Hopenhayn, Hugo A & Nicolini, Juan Pablo, 1997. "Optimal Unemployment Insurance," Journal of Political Economy, University of Chicago Press, vol. 105(2), pages 412-438, April.
    25. Silva, José Ignacio & Toledo, Manuel, 2009. "Labor Turnover Costs And The Cyclical Behavior Of Vacancies And Unemployment," Macroeconomic Dynamics, Cambridge University Press, vol. 13(S1), pages 76-96, May.
    26. Álvarez-Parra, Fernando & Sánchez, Juan M., 2009. "Unemployment insurance with a hidden labor market," Journal of Monetary Economics, Elsevier, vol. 56(7), pages 954-967, October.
    27. Haoming Liu & Jinli Zeng, 2008. "Determinants of Long-Run Unemployment," Southern Economic Journal, Southern Economic Association, vol. 74(3), pages 775-793, January.
    28. Walter Nicholson & Karen Needels, 2006. "Unemployment Insurance: Strengthening the Relationship between Theory and Policy," Journal of Economic Perspectives, American Economic Association, vol. 20(3), pages 47-70, Summer.
    29. Arthur J. Hosios, 1990. "On The Efficiency of Matching and Related Models of Search and Unemployment," Review of Economic Studies, Oxford University Press, vol. 57(2), pages 279-298.
    Full references (including those not matched with items on IDEAS)


    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.

    Cited by:

    1. Wang, Cheng & Williamson, Stephen D., 2002. "Moral hazard, optimal unemployment insurance, and experience rating," Journal of Monetary Economics, Elsevier, vol. 49(7), pages 1337-1371, October.
    2. Wang, Cheng & Williamson, Stephen, 1996. "Unemployment insurance with moral hazard in a dynamic economy," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 44(1), pages 1-41, June.
    3. Jeremy Schwartz, 2019. "The Job Search Intensity Supply Curve: How Labor Market Conditions Affect Job Search Effort," Eastern Economic Journal, Palgrave Macmillan;Eastern Economic Association, vol. 45(2), pages 269-300, April.

    More about this item


    United States; Labor market issues; Business cycles;

    JEL classification:

    • J65 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Unemployment Insurance; Severance Pay; Plant Closings
    • J64 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Unemployment: Models, Duration, Incidence, and Job Search
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles


    Access and download statistics


    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:ekd:002672:3674. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Theresa Leary). General contact details of provider: .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.