On the Welfare Effect of Cyclical Policies under Incomplete Markets and Labor Market Frictions

This paper examines how policies affect people's welfare during business cycles when markets are incomplete. In particular, we analyze cyclical policies such as cyclical taxation and cyclical unemployment insurance. Those policies play two roles: smoothing the income (and consumption) process for each individual and reallocate the risks among individuals. The latter role arises since when markets are incomplete, aggregate shocks affect people differently. Our analysis focuses on the channel through the labor market. For this aim, we model labor market frictions explicitly utilizing the standard Diamond-Mortensen-Pissarides framework