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Pro-cyclical Unemployment Benefits? Optimal Policy in an Equilibrium Business Cycle Model

  • Kurt Mitman

    ()

    (Department of Economics, University of Pennsylvania)

  • Stanislav Rabinovich

    ()

    (Department of Economics, University of Pennsylvania)

We study the optimal provision of unemployment insurance (UI) over the business cycle. We use an equilibrium search and matching model with aggregate shocks to labor productivity, incorporating risk-averse workers, endogenous worker search effort decisions, and unemployment benefit expiration. We characterize the optimal UI policy, allowing both the benefit level and benefit duration to depend on the history of past aggregate shocks. We find that the optimal benefit is decreasing in current productivity and decreasing in current unemployment. Following a drop in productivity, benefits initially rise in order to provide short-run relief to the unemployed and stabilize wages, but then fall significantly below their pre-recession level, in order to speed up the subsequent recovery. Under the optimal policy, the path of benefits is pro-cyclical overall. As compared to the existing US UI system, the optimal history-dependent benefits smooth cyclical fluctuations in unemployment and deliver substantial welfare gains.

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Paper provided by Penn Institute for Economic Research, Department of Economics, University of Pennsylvania in its series PIER Working Paper Archive with number 11-023.

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Length: 43 pages
Date of creation: 07 Aug 2011
Date of revision:
Handle: RePEc:pen:papers:11-023
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  2. Etienne Lehmann & Bruno Van Der Linden, 2007. "On the Optimality of Search Matching Equilibrium When Workers Are Risk Averse," Journal of Public Economic Theory, Association for Public Economic Theory, vol. 9(5), pages 867-884, October.
  3. Andersen, Torben M. & Svarer, Michael, 2010. "Business Cycle Dependent Unemployment Insurance," IZA Discussion Papers 5196, Institute for the Study of Labor (IZA).
  4. Hosios, Arthur J, 1990. "On the Efficiency of Matching and Related Models of Search and Unemployment," Review of Economic Studies, Wiley Blackwell, vol. 57(2), pages 279-98, April.
  5. Meyer, Bruce D, 1990. "Unemployment Insurance and Unemployment Spells," Econometrica, Econometric Society, vol. 58(4), pages 757-82, July.
  6. Michael T. Kiley, 2003. "How should unemployment benefits respond to the business cycle?," Finance and Economics Discussion Series 2003-01, Board of Governors of the Federal Reserve System (U.S.).
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  8. Melvyn Coles & Adrian Masters, 2006. "Optimal Unemployment Insurance in a Matching Equilibrium," Journal of Labor Economics, University of Chicago Press, vol. 24(1), pages 109-138, January.
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  14. Fredriksson, Peter & Holmlund, Bertil, 2001. "Optimal Unemployment Insurance in Search Equilibrium," Journal of Labor Economics, University of Chicago Press, vol. 19(2), pages 370-99, April.
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  16. Baily, Martin Neil, 1978. "Some aspects of optimal unemployment insurance," Journal of Public Economics, Elsevier, vol. 10(3), pages 379-402, December.
  17. Simon Burgess & Helene Turon, 2005. "The Cyclical Behavior of Equilibrium Unemployment and Vacancies – A Comment," Bristol Economics Discussion Papers 05/573, Department of Economics, University of Bristol, UK.
  18. Wouter J. den Haan & Garey Ramey & Joel Watson, 1997. "Job Destruction and Propagation of Shocks," NBER Working Papers 6275, National Bureau of Economic Research, Inc.
  19. Moffitt, Robert, 1985. "Unemployment insurance and the distribution of unemployment spells," Journal of Econometrics, Elsevier, vol. 28(1), pages 85-101, April.
  20. Hopenhayn, H. & Nicolini, P.J., 1996. "Optimal Unemployment Insurance," RCER Working Papers 421, University of Rochester - Center for Economic Research (RCER).
  21. Fishe, Raymond P H, 1982. "Unemployment Insurance and the Reservation Wage of the Unemployed," The Review of Economics and Statistics, MIT Press, vol. 64(1), pages 12-17, February.
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  23. Sánchez, Juan M., 2008. "Optimal state-contingent unemployment insurance," Economics Letters, Elsevier, vol. 98(3), pages 348-357, March.
  24. 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.
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