The cost of business cycles and the stabilization value of unemployment insurance

This paper offers a new perspective on why labor market policies aimed at reducing the cost of business cycles may be warranted and how such policies can be designed in order to improve welfare, To this end, we develop a quantitative dynamic equilibrium model to illustrate how the contractual structure of the labor market may hide significant undiversified wage risk induced by aggregate fluctuations. The environment analyzed is such that the only imperfectly diversified risk workers bear is the risk of losing their job when the market for new contracts is depressed, When we fit the model to replicate the amount of wage variation estimated from micro-data, we obtain estimates of the potential value of stabilization policies that are substantially larger than those found in the literature. We use this framework to examine several policy issues and, in particular, to show why state-contingent unemployment insurance may dominate non-contingent unemployment insurance schemes. (C) 2001 Elsevier Science B.V. All rights reserved.