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

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  • Jeremy Schwartz

Abstract

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
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    References listed on IDEAS

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    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.
    4. Schwartz Jeremy, 2020. "Job competition, human capital, and the lock-in effect: can unemployment insurance efficiently allocate human capital," The B.E. Journal of Macroeconomics, De Gruyter, vol. 20(1), pages 1-23, January.

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