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

By Kurt Mitman and Stanislav Rabinovich

We study the optimal provision of unemployment insurance (UI) over the business cycle. We consider an equilibrium Mortensen-Pissarides search and matching model with risk-averse workers and aggregate shocks to labor productivity. Both the vacancy creation decisions of firms and the search effort decisions of workers respond endogenously to aggregate shocks as well as to changes in UI policy. We characterize the optimal history-dependent UI policy. We find that, all else equal, the optimal benefit is decreasing in current productivity and decreasing in current unemployment. Optimal benefits are therefore lowest when current productivity is high and current unemployment is high. The optimal path of benefits reacts non-monotonically to a productivity shock. 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 non-negligible welfare gains.

This is an interesting paper on optimal UI benefits. The interesting twist is that the Mortensen-Pissarides matching in the model allows to take into account the vacancy creation effect of changes in the outside option of unemployed workers. This leads to rich dynamics in UI benefits following an aggregate shock.

One Response to Pro-Cyclical Unemployment Benefits? Optimal Policy in an Equilibrium Business Cycle Model

  1. First of all, we want to thank Chris for choosing our paper for discussion this week. You really hit the nail on the head with your summary. We were inspired by the seminal work on the provision of Optimal Unemployment Insurance (e.g. Hopenhayn and Nicolini, Shimer and Werning), but what struck us was that most of the literature focused only on the moral hazard distortion. Given the magnitude of the total amount of unemployment benefits paid out during recessions, we wondered how this might affect firm’s decisions to post vacancies and create new jobs. We found that the firm distortion is actually significant and drives a lot of our results. One of the limitations of our current analysis is that we have abstracted from duration dependence of unemployment benefits. We are currently extending our model to allow the government to choose both the level and duration of benefits to see how the optimal benefit policy looks when the government has both policy levers at its disposal.

    We welcome any thoughts, comments or suggestions about the paper. Stan will be presenting it at several conferences this summer (including SED, EEA, Midwest Macro) hopefully including some of our new results, so if you’re in attendance we’d love to get your feedback.

    Kurt and Stan

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