Affiliation: Shanghai University of Finance and Economics
Title: "Baily-Chetty Formula Without Apology: A General Equilibrium Analysis"
Abstract: How quantitatively significant are general equilibrium effects in characterizing optimal unemployment insurance (UI) benefits? We answer this question by building a model with incomplete financial markets and labor market frictions. In our model, firms make decisions on entry; households make efforts to search for a job and save assets as partial insurance against unemployment and persistent labor productivity shocks. We align our model so that the Baily-Chetty formula holds with the model-implied micro elasticity of unemployment duration but not under general equilibrium effects. We find that the response of the equilibrium interest rate to UI benefits is tiny. Therefore, the optimal UI level is close to that meeting the Baily-Chetty formula (- 7 percent), and compared to the UI induced by the Baily-Chetty formula, the optimal UI shows minuscule improvements in welfare (0.004 percent). The stagnant change in the equilibrium interest rate is because an increase in UI benefits produces two offsetting forces: a reduction in households’ precautionary savings due to more insurance and a decrease in firms’ capital demand due to more unemployment. These findings suggest that the sufficient statistics approach with the Baily-Chetty formula provides a good approximation for the optimal UI benefits.