Dynamic Effects of Unemployment Insurance Reform

We study the transition dynamics and welfare effects of reducing unemployment benefits in a Mortensen-Pissarides matching model with precautionary savings. The dynamic analysis reveals significant transition costs that comparative statics would miss. The main reason is that initially individuals have to increase savings to self-insure. Nevertheless moderate benefit reductions increase average welfare of workers. Gains are much larger when the reform isannounced in advance or phased in optimally. Workers can then extract windfalls otherwise accruing to firms with filled jobs which stem from the jump in vacancy costs following an unexpected reform. If instead of the standard periodic vacancy cost we assume hiring to involve a fixed cost, welfare gains also increase because there is no crowding out of efficiency gains through rising hiring costs and hence no windfall. One-off reforms are then optimal.