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Optimal unemployment insurance and cyclical fluctuations

Author

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  • Rui Li
  • Noah Williams

Abstract

The authors study the design of optimal unemployment insurance in an environment with moral hazard and cyclical fluctuations. The optimal unemployment insurance contract balances the insurance motive to provide consumption for the unemployed with the provision of incentives to search for a job. This balance is affected by aggregate conditions, as recessions are characterized by reductions in job finding rates. We show how benefits should vary with aggregate conditions in an optimal contract. In a special case of the model, the optimal contract can be solved in closed form. We show how this contract can be implemented in a rather simple way by allowing unemployed workers to borrow and save in a bond (whose return depends on the state of the economy), providing flow payments that are constant over an unemployment spell but vary with the aggregate state, and giving additional lump-sum payments (or charges) upon finding a job or when the aggregate state switches. We then consider a calibrated version of the model and study the quantitative impact of changing from the current unemployment system to the optimal one. In a recession, the optimal system reduces unemployment rates by roughly 2.5 percentage points and shortens the duration of unemployment by about 50 percent.

Suggested Citation

  • Rui Li & Noah Williams, 2015. "Optimal unemployment insurance and cyclical fluctuations," FRB Atlanta CQER Working Paper 2015-2, Federal Reserve Bank of Atlanta.
  • Handle: RePEc:fip:fedacq:15-02
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    References listed on IDEAS

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    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Optimal Unemployment Insurance and Cyclical Fluctuations
      by Christian Zimmermann in NEP-DGE blog on 2015-11-13 20:31:54

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    More about this item

    Keywords

    optimal contracts; unemployment benefits; lump-sum payments; welfare; unemployment durations;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles

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