A Quantitative Theory of Time-Consistent Unemployment Insurance

Yun Pei and Zoe Xie

Working Paper 2016-11a
Revised December 2017

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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 extensions. Because of the trade-off between insurance and job search incentives, the classic time-inconsistency problem arises. We endogenize 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 duration increases the unemployed workers’ consumption but reduces their job search incentives, leading to higher future unemployment. We use the framework to evaluate the effects of the 2008-2013 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 for their insight and support. We thank seminar and conference participants at the University of Minnesota, the Federal Reserve Bank of Minneapolis, the Federal Reserve Bank of Atlanta, the University of Florida, the University of Georgia, the University of Southern California, and Midwest Macro Conference at Purdue University. 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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