Optimal Unemployment Insurance and Cyclical Fluctuations

In this paper, we investigate 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 risk-free bond, providing flow payments which 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 roughly 50%.