Moral Hazard vs. Liquidity in Unemployment Insurance,UC-Berkeley mimeo (2006b

It is well known that unemployment benefits raise unemployment durations. This result has been interpreted as a moral hazard response to distorted incentives. This paper shows that unemployment benefits also raise durations through a “liquidity ” effect for households who cannot smooth consumption perfectly. The empirical importance of the liquidity effect in documented in two ways. First, state-level increases in unemploy-ment benefits have large effects on durations for liquidity constrained (e.g. low-asset) households, but small effects for unconstrained households. Second, lump-sum sever-ance payments significantly increase durations among constrained households. These results suggest that unemployment benefits affect search behavior primarily through the provision of liquidity rather than moral hazard. Using a job search model, I derive a new test for the optimal level of unemployment benefits in terms of the magnitude of the liquidity effect relative to moral hazard. Implementing this test using the em-pirical estimates implies that the optimal wage replacement rate for UI is above 50%, considerably higher than the findings of some earlier studies