Unemployment Dynamics and Unemployment Insurance Extensions under Rational Expectations

This paper investigates the impact of partially endogenous unemployment insurance (UI) extensions on the dynamics of unemployment and its duration structure in the US. Using a search and matching model with endogenous separations, variable job search intensity, on-the-job search and worker heterogeneity, I allow for the maximum UI duration to depend on unemployment and for UI benefits to depend on observable employment characteristics. The model can account for a large fraction of the observed rise in the long-term unemployment and realistic dynamics of the unemployment duration distribution during the Great Recession. Eliminating all UI extensions during the Great Recession could potentially lower the unemployment rate by 0.9-3.4 percentage points via both the responses of job search and vacancy posting incentives. Disregarding rational expectations about the timing of UI extensions implies an overestimation of unemployment by up to 2 percentage points. Once the heterogeneity in UI status and benefit level is accounted for, unobserved heterogeneity of workers does not account for much of the incidence of long-term unemployment.