Unemployment Insurance and Unemployment Volatility

We develop a search and matching model where idiosyncratic risk and liquidity constraints induce precautionary savings. In this economy, aggregate TFP shocks induce fluctuations in the stochastic discount factor by affecting idiosyncratic uncertainty. This propagation mechanism successfully generates sufficient volatility in unemployment rates to match the US data, along with a unit elasticity of both wages and opportunity cost of work to productivity. The model generates two key predictions that are in contrast with those obtained in search and matching models with standard amplification mechanisms: first, the model successfully replicates the fact that fluctuations in the market value of firms are mostly driven by discount factors rather than cashflows. Second, it predicts that higher unemployment insurance smooths the impact of shocks in recessions. Evidence based on a panel of OECD countries validates the hypothesis that unemployment benefits operate as automatic stabilisers.