Optimal Unemployment Insurance over the Business Cycle

This paper analyzes optimal unemployment insurance (UI) over the business cycle. We consider a general matching model of the labor market. For a given UI, the economy is efficient if tightness satisfies a generalized Hosios condition, slack if tightness is too low, and tight if tightness is too high. The optimal UI formula is the sum of the standard Baily-Chetty term, which trades off search incentives and insurance, and an externality-correction term, which is positive if UI brings the economy closer to efficiency and negative otherwise. Our formula therefore deviates from the Baily-Chetty formula when the economy is inefficient and UI affects labor market tightness. In a model with rigid wages and concave production function, UI increases tightness; hence, UI should be more generous than in the Baily-Chetty formula when the economy is slack, and less generous otherwise. In contrast, in a model with linear production function and Nash bargaining, UI increases wages and reduces tightness; hence, UI should be less generous than in the Baily-Chetty formula when the economy is slack, and more generous otherwise. Deviations from the Baily-Chetty formula can be quantitatively large using realistic empirical parameters.