Unemployment insurance and self-fulfilling business cycles

Abstract We study the macroeconomic role of unemployment insurance in an economy with job search, labor force participation decisions, and involuntary unemployment. The framework allows labor market distortions to vary endogenously over the business cycle and, under certain conditions, to amplify economic fluctuations. We show that unemployment insurance can reduce the scope for such destabilizing dynamics and thereby act as an effective automatic stabilizer. Quantitative analysis indicates that while these dynamics may arise at unemployment benefit levels comparable to those observed in North America, they are unlikely at the higher replacement rates typical of European countries. Overall, our results suggest that unemployment insurance not only provides social insurance but can also contribute to macroeconomic stability, with important implications for the design of labor market policies over the business cycle.