Optimal Unemployment Insurance in a Directed Search Model

Over the last few decades, several economies have experienced a reduction in the volatility of output and a rise in wage dispersion. This paper investigates the appropriate labor market policy response to these changes. We introduce unemployment benets nanced by a proportional payroll tax within a model of directed search on the job. We show that there exists a unique positive level of unemployment benet which maximizes ex ante welfare of individuals. The optimal unemployment benet level is hump-shaped as a function of the level of idiosyncratic risk. At empirically relevant levels of idiosyncratic risk, a much less generous system than in the economy without uncertainty emerges. Furthermore, the welfare costs of deviating from the optimal level are substantial, and accompanied by high unemployment rates. We also nd that while the optimal generosity of the unemployment insurance system declines monotonically with the amount of aggregate risk in the economy, the welfare costs of deviating from the optimal system are rather small.