Should Unemployment Insurance Vary With the Unemployment Rate? Theory and Evidence

We study theoretically and empirically how optimal unemployment insurance (UI) benefits vary over the business cycle. Theoretically, we characterize how the moral hazard cost and the consumption smoothing benefit of UI vary over the business cycle in a standard job search model. This analysis motivates our empirical strategy which tests whether the effect of UI on unemployment durations and the consumption drop at unemployment varies with the unemployment rate. In our preferred specification, we find that a one standard deviation increase in the state unemployment rate reduces the magnitude of the duration elasticity by 42%. By contrast, using consumption changes upon unemployment, we do not find evidence that the consumption smoothing benefit of UI varies with the unemployment rate. Combining these empirical estimates to calibrate the optimal level of UI benefits implied by our model, we find that a one standard deviation increase in the unemployment rate leads to a 9 to 17 percentage point increase in the optimal replacement rate. (JEL H5, J64, J65) ∗E-mail: [email protected]; [email protected]. We thank Joe Altonji, Judy Chevalier, Jonathan Guryan, Erzo Luttmer, Andrew Metrick, Giuseppe Moscarini, Fiona Scott Morton, and seminar participants at Chicago Booth, LSE, MIT, Federal Reserve Bank of Philadelphia, University of Texas at Austin, University of Toronto, and Yale SOM for providing excellent comments. We thank Jesse Burkhardt amd Christian Goldammer for providing outstanding research assistance. Notowidigdo gratefully acknowledges the National Institute of Aging (NIA grant number T32-AG000186) for financial support.