Liquidity and Insurance for the Unemployed

This paper argues that there are two distinct components in an optimal policy for the unemployed: insuring workers against uncertainty in the prospect of finding a job; and providing workers with the liquidity to smooth consumption while unemployed. In contrast to the leading papers on the optimal contracting approach to unemployment insurance 1Steven Shavell and Laurence Weiss 1979; Hugo A. Hopenhayn and Juan Pablo Nicolini 19972 , we distinguish between these roles by allowing workers to borrow and save. Our main conclusion is that a constant or nearly constant benefit schedule is optimal. This insures workers against unemployment risk, while their ability to dissave and borrow allows them to avoid transitory fluctuations in consumption. The dichotomy between liquidity and insurance is consistent with the spirit of Martin Feldstein and Daniel Altman’s 119982 proposal for unemployment insurance savings accounts 1see also Feldstein 20052 . We represent an unemployed worker’s situation using John J. McCall’s 119702 model of sequential job search. A risk-averse, infinitely lived worker periodically gets a wage offer from a known distribution. If she accepts the offer, she keeps the job at a constant wage forever. If she rejects it, she continues to search. We compare two unemployment insurance policies. Under constant benefits, the worker receives a constant benefit while she is unemployed and pays a constant tax once she is employed. The worker can borrow and lend using a riskless bond. We show that the worker adopts a reservation wage that is increasing in both the unemployment benefit and the employment tax, a form of moral hazard. An insurance agency sets the level of benefits and taxes to minimize the cost of providing the worker with a given amount of utility. We then consider optimal unemployment insurance. An insurance agency dictates a durationdependent consumption level for the unemployed, funded by an employment tax that depends on Liquidity and Insurance for the Unemployed