A Quantitative Theory of Time-Consistent Unemployment Insurance

Yun Pei and Zoe Xie

Working Paper 2016-11
November 2016

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During recessions, the U.S. government substantially increases the duration of unemployment insurance (UI) benefits through multiple extensions. This paper seeks to understand the incentives driving these increases. Because of the trade-off between insurance and job search incentives, the classic time-inconsistency problem arises. This paper endogenizes a time-consistent UI policy in a stochastic equilibrium search model, where a government without commitment to future policies chooses the UI benefit level and expected duration each period. A longer benefit duration increases unemployed workers’ consumption but reduces job search, leading to higher future unemployment. Quantitatively, the model rationalizes most of the variations in benefit duration during the Great Recession. We use the framework to evaluate the effects of the 2009–13 benefit extensions on unemployment and welfare.

JEL classification: E61, J64, J65, H21

Key words: time-consistent policy, unemployment insurance, labor market, business cycle

The authors are grateful to José-Víctor Ríos-Rull, Jonathan Heathcote, Sam Schulhofer-Wohl, and Richard Rogerson for their insightful comments. This paper has benefited from discussions with Hengjie Ai, Toni Braun, Lei Fang, Si Guo, Zhen Huo, Tasos Karantounias, Rishabh Kirpalani, Karen Kopecky, Federico Mandelman, Stan Rabinovich, Filippo Rebessi, and Kei-Mu Yi. 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 Yun Pei, Department of Economics, State University of New York at Buffalo, 415 Fronczak Hall, Buffalo, NY 14260, yunpei@buffalo.edu, or Zoe Xie, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street NE, Atlanta, GA 30309, xiexx196@gmail.com.
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