NCPA - National Center for Policy Analysis


September 29, 2008

Traditionally, unemployment insurance (UI) benefits are said to reduce the labor supplied by those who are eligible for such benefits.  UI reduces the net wage associated with finding a new job, and it makes leisure relatively more attractive than working, reducing economic efficiency and welfare.  However, the National Bureau of Economic Research (NBER) questions whether the link between unemployment benefits and the duration of unemployment is attributable only to this traditional net wage effect, or whether it might depend on the cash-on-hand available to unemployed individuals (or liquidity).

Using a dataset of more than 4,500 unemployment spells, NBER shows that increases in UI benefits have much larger effects on the duration of unemployment for liquidity-constrained households (that is, households with low levels of liquid wealth) than for other households:

  • Nearly half of the unemployed in the United States report no liquid wealth at the time they lose their job, suggesting that many households may be unable to weather even a temporary shock to their income.
  • A majority of the increase in the duration of unemployment caused by UI benefits actually is attributable to the liquidity effect.
  • Lump-sum severance payments were found to increase the duration of unemployment substantially among liquidity-constrained households.
  • Because lump-sum severance payments are cash grants that do not distort the individual's net wage, this constitutes direct evidence that liquidity effects are large.

Overall, 60 percent of the increase in unemployment duration caused by UI benefits is attributable to the liquidity effect.

Furthermore, the UI program yields significant welfare gains by providing liquidity, despite reducing efficiency by making work less attractive, says NBER.

Source: Raj Chetty, "Moral Hazard vs. Liquidity and Optimal Unemployment Insurance," National Bureau of Economic Research, Working Paper, No. 13967, April 2008.

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