On the Reservation Wages and Liquidity Constraint

This paper argues that a risk averse of workers after-tax reservation wage the difference between her reservation wage and the tax needed to fund the unemployment insurance system when liquidity constraint binds exists and it is unique. The optimality of unemployment insurance based on the responsiveness of reservation wage to unemployment benefit shows the disincentive effect, i.e. higher unemployment benefit will increase workers after tax reservation wage that will make the exit rate lower. This shows that there is a moral hazard problem. The more one tries to protect the worker against unemployment by raising unemployment benefits and funding the benefits by an employment tax, the more selective she becomes.