Consumption and Savings with Unemployment Risk: Implications for Optimal Employment Contracts

This paper derives analytically consumption and asset profiles when there are employment and unemployment risks and moral hazard. Without perfect insurance, consumption rises during employment and falls during unemployment. Optimal employment contracts that offer severance compensation smooth consumption during employment without causing moral hazard. A pre-announced delay in separation when the job becomes unproductive provides further insurance but because of moral hazard it does not fully smooth consumption. During the delay consumption falls and the worker searches for another job. No delays in separations are optimal if the level of exogenous unemployment compensation is sufficiently high. Employment contracts often contain provisions for the payment of severance compensation to dismissed employees, or for delays in dismissals. The most common procedure that delays dismissal is the requirement to give a notice of fixed duration before dismissal. There are, however, other procedures. In many countries, minimum levels of severance compensation and dismissal delays are written in employment laws but private contracts contain similar, if not more, stringent requirements. The OECD (1999) reports that on average in its member countries employers are required to give minimum advance notice of dismissal of 1.6 months to employees of four years standing and to ∗Earlier versions of this paper were read at the NBER Summer Institute, July 2001, and Princeton University. I have benefited from comments and discussions with Chris Carol, Raquel Fernandez, Rasmus Lentz, Eva Nagypal, Robert Shimer, Michael Woodford, Sevin Yeltekin and other seminar participants.