Unemployment Insurance, Informality, and Precautionary Savings

Empirical evidence shows that in a labor market characterized by a severe degree of informality, unemployment insurance (UI) has different effects that most of the literature, based on developed countries, address. First, UI takers are incentivized to work in the informal sector while collecting benefits. Second, UI distorts the precautionary savings motive, affecting the worker decision and firms' incentives to post vacancies. Considering those facts, we build a search and matching model that incorporates informality in an incomplete markets framework to analyze the impact of changing (UI) components. In particular, we consider a UI design that allows eligibility and exhaustion. Moreover, we also enable workers to receive benefits while working in informality. We find that increasing the benefit eligibility criteria fosters employment while the duration and replacement rate barely affects the unemployment rate. On the other hand, the benefit duration is the key component to understanding the interaction between informality and UI. We also find that the optimal design occurs when more insurance is provided in this economy, away from the literature of UI with search frictions and incomplete markets. The welfare rises 0.32% because of the indirect effect of UI on informal wages through precautionary savings. However, when we allow every worker to collect the benefit, we find the opposite, with solid support to shut down the benefit due to the harm caused on vacancy posting of formal firms, which increases unemployment