Equilibrium Underemployment

This paper develops a model of human capital investment in a frictional labor market with two-sided heterogeneity and liquidity constraints. The model generates underemployment in equilibrium: workers are employed in jobs for which they are over-qualified. Subsidizing education can decrease the returns to human capital investment, increase the underemployment rate, and decrease the unemployment rate. I calibrate the model to the U.S. economy and find the aggregate supply of human capital and underemployment rate are inefficiently low. The constrained-efficient allocation is implemented by increasing education subsidies and unemployment benefits by 9.63% and 35.5%, respectively