Rui Li and Noah Williams
CQER Working Paper 15-02
August 2015

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The authors study the design of optimal unemployment insurance in an environment with moral hazard and cyclical fluctuations. The optimal unemployment insurance contract balances the insurance motive to provide consumption for the unemployed with the provision of incentives to search for a job. This balance is affected by aggregate conditions, as recessions are characterized by reductions in job finding rates. We show how benefits should vary with aggregate conditions in an optimal contract. In a special case of the model, the optimal contract can be solved in closed form. We show how this contract can be implemented in a rather simple way by allowing unemployed workers to borrow and save in a bond (whose return depends on the state of the economy), providing flow payments that are constant over an unemployment spell but vary with the aggregate state, and giving additional lump-sum payments (or charges) upon finding a job or when the aggregate state switches. We then consider a calibrated version of the model and study the quantitative impact of changing from the current unemployment system to the optimal one. In a recession, the optimal system reduces unemployment rates by roughly 2.5 percentage points and shortens the duration of unemployment by about 50 percent.

JEL classification: E32

Key words: optimal contract, unemployment benefits, lump-sum payments, welfare, unemployment durations

The authors thank Narayana Kocherlakota and Rasmus Lentz for helpful comments. Hsuan-Chih (Luke) Lin provided excellent research assistance. Financial support from the National Science Foundation is gratefully acknowledged. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.
Please address questions regarding content to Rui Li, Department of Accounting and Finance, University of Massachusetts–Boston, 100 Morrissey Boulevard, Boston, MA 02125-3393, 617-287-3182, rui.li@umb.edu or Noah Williams (contact author), Department of Economics, University of Wisconsin–Madison, William H. Sewell Social Science Building, Room 7434, 1180 Observatory Drive, Madison, WI 53706-1393, 608-263-3864, nwilliam@ssc.wisc.edu.
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