Household Income, Liquidity, and Optimal Unemployment Insurance

We examine the optimal provision of unemployment insurance (UI) benefits in a directed search model with matching frictions. Workers have differing levels of liquidity to smooth consumption during an unemployment spell. The model allows workers to choose between paying a fixed cost to collect the government provided UI benefits, or to forgo this scheme. Non-collectors do not receive liquid UI benefits, but do experience a shorter expected unemployment duration. Using data from the SIPP and a Mixed Proportional Hazard (MPH) model, we estimate jointly the decision to collect UI benefits and the risk of going back to work, which yields several novel results with policy implications. Households with lower liquidity are less likely to opt into the government UI scheme, as the need to find a job quickly outweighs the short-lived liquidity provided by UI benefits. The MPH estimation also finds that collecting benefits significantly lengthens the duration of unemployment. The model is calibrated to the empirical results. The optimal policy in the calibrated economy features a relatively high replacement rate and short potential duration.