Unemployment Insurance and the Business Cycle: What Adjustments Are Needed?

[Author Affiliation]Jeremy Schwartz, * Loyola University Maryland, Department of Economics, 4501 North Charles Street Sellinger 315, Baltimore, MD 21210, USA; E-mail: jsschwartz1@loyola.edu .[Acknowledgment]I wish to thank Donald Parsons, Kerry Richmond, Tara Sinclair, Roberto Samaniego, and Anthony Yezer for their helpful comments and discussions regarding this article.1. IntroductionIn most developed countries, unemployment insurance (UI) is a static program that remains constant regardless of labor market conditions. The United States, along with Canada, are the only OECD countries that routinely adjust the generosity of their UI programs with the business cycle. For instance, during the 2007-2011 labor market downturn, the length of time that UI benefits could be collected in the United States increased to an unprecedented 99 weeks from the standard 26 weeks available under "normal" economic conditions, and the weekly benefit amount increased by $25. From an insurance perspective, losing one's job during a recession is a greater loss than during an expansion, and consequently, a greater benefit may be appropriate. However, it is also known that increasing UI generosity has a negative effect on job search intensity and puts upward pressure on wages leading to lower job creation. Given these benefits and costs, I seek to answer the following questions. What structure of benefits over the business cycle is welfare-maximizing? Is the current policy of increasing the generosity of UI during recessions optimal?To accomplish this, I develop a dynamic search model of the U.S. labor market, which connects two parts of the optimal UI literature. The first takes a partial equilibrium approach to determine the optimal adjustments to UI when job-finding rates fall but does not consider UI's impact on job creation. The second endogenizes job creation but does not address how the benefit system should adjust with the business cycle. The model I present is unique in that it allows for both.Similar to studies that use the partial equilibrium approach, one of the main factors driving the optimal UI program in this article is the moral hazard problem that arises from the inability to monitor the unemployed's job search. Shavell and Weiss's (1979) seminal work shows that a sequence of UI benefits that declines with the length of unemployment provides the necessary incentives to encourage job search when the government's objective is to maximize welfare, subject to a fixed budget. Although not explicitly modeling firm behavior, Hansen and Imrohoroglu (1992) allow the UI budget to be endogenously determined, similar to this article. The authors also frame the moral hazard problem in terms of the government's inability to monitor rejections of job offers as well as allow for private savings. They find that the optimal replacement rate is quite low, just 0.15 in their baseline moral hazard case. Hopenhayn and Nicolini (1997) focus on unobservable search intensity and develop a widely used recursive contract approach to determine the cost-minimizing UI benefit schedule and employment tax, where the policy parameters are contingent on an individual's complete work history. A benefit amount that declines during one's unemployment spell and a subsequent employment tax that increases with the length of unemployment is optimal and results in utility falling continuously during unemployment. Pavoni (2007) extends this approach by including a guaranteed lower bound on utility, which results in an optimal benefit schedule that falls sharply and includes a one time drop in benefits to a subsistence level. Alvarez-Parra and Sanchez (2009) explicitly model this lower bound by including a hidden labor market where workers can continue to receive UI benefits undetected. In this study, the optimal benefit schedule falls slowly at first to ensure workers search in the formal sector and then falls sharply to zero, allowing workers to derive consumption from the informal sector. …