How Unemployment Benefits Boost Growth
It might sound counter-intuitive, but the presence of unemployment benefits encourage taking more risks with your next job.
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Changing jobs can be both exciting and scary. As I am currently in that process, I have definitely already experienced both feelings. Financial security is always on one’s mind and I am fortunate to have some, as it allows me to explore going full time on Nominal News.
Governments provide the public such financial security through unemployment insurance (UI). It turns out also that UI can be an important factor driving economic growth as shown in a recent paper by Clymo, Denderski Mercan and Schoefer (2026) (“CDMS”).
What You’ll Discover Today:
How unemployment insurance encourages job creation;
How unemployment insurance also boosts productivity;
Why we may need to consider unemployment insurance expansion in recessions.
Excessive Caution
An employed individual may naturally be worried about switching jobs. Going to a new job comes with inherent risks, one of which is what if the new job doesn’t work out and ends up terminating you. Faced with this uncertain risk of termination at a new job, a worker may be less inclined to switch jobs. This excessive, yet reasonable, caution can lead to worse outcomes for all.
UI may help with alleviating some of this risk. How?
Unemployment Insurance
To model the impact of UI, the authors, CDMS, assume a job is defined by two characteristics:
how productive is it (for example, how much revenue it will generate)
what is the likelihood the job will be terminated (e.g. how likely is the company to survive)
The wage a worker will receive is a function of these two things.1
The worker can decide whether to accept a job offer or not. If the worker accepts the offer, they receive a wage; if not, they receive UI.
Whilst on the job, the worker can receive job offers from other firms as well. As before, the job offer they get is described by the productivity level and job security level.
Intuition
It is intuitive that a worker can be indifferent between two jobs – one job that offers higher wages but lower job security is of equivalent value to a job that offers lower wages but higher job security.
Since the biggest worry for a person taking a higher risk job is becoming unemployed, UI can help mitigate this fear by providing a worker with some money in case they do become unemployed. The higher the UI, the more likely a worker should be willing to take a riskier job.
CDMS formally analyzed this with a survey2 to elicit how people view the wage vs security trade off. In this survey. CDMS found that:
for a 1 percentage point higher probability of job loss, workers on average demand 1.63% higher wage;
For an identical 1 percentage point higher probability of job loss, workers in higher paying jobs require a 1.9% wage increase compared to workers in lower paying jobs, who only require a 1.3% wage increase;
For an identical 1 percentage point higher probability of job loss, workers in safer jobs require a 2.1% increase in wage increase compared to workers in riskier jobs who only require a 0.96% wage increase.
Consumption and Saving
Lastly, as is classic with most economic models, the worker chooses how much to consume each period and how much to save. Saving acts as a basic form of self-insurance from unemployment.
The CDMS model distills the world into a simple yet reasonable reflection of the world, as workers:
Make a trade off between wages and job security;
Consume or save.
Job Creation
The really interesting element of the CDMS model is that the decisions workers make also influence job creation. If workers are unlikely to switch jobs, firms are less likely to form and post job offers (posting a job entails a cost), as they are less likely to find a worker willing to join them.
At the same time, with higher unemployment insurance, workers are also less likely to accept jobs, again discouraging firms from posting jobs. This implies that there is an optimal level of UI, as both effects need to be balanced.
Bringing in Data
As the last step, CDMS calibrated the model to US data. In the US, unemployment insurance typically replaces around 40% of an unemployed person’s previous wage (this is called the replacement rate).
CDMS ran a counterfactual analysis by dropping unemployment insurance to about a 10% replacement rate. In this scenario, overall US productivity would fall by about 1.3%, while output would also fall by around 0.4%.
This would be primarily driven by the fact that job to job transitions collapse. The cost of becoming unemployed is simply too high. In turn, there are fewer risky-type firms entering the economy, which is why productivity and output fall.
Recessions
The really interesting situation arises during recessions. During recessions, the likelihood of becoming unemployed typically rises significantly for every type of job. This makes safer jobs even more desirable and reduces the willingness to switch jobs, as workers ‘flee to safety’. In turn, this rational, albeit conservative, behavior may further exacerbate the recession. Thus, CDMS propose a policy where the replacement rate of unemployment insurance is increased during recessions, to offset the effect of flight to safety.
For example, during the 2008 recession, to fully offset the flight to safety, the UI replacement rate of income would need to be increased temporarily by 50% to a 60% replacement rate.This higher replacement rate encourages workers to switch into riskier jobs, restoring productivity growth. It does result in a higher level of unemployment, since workers now are compensated better in unemployment, and thus, are more picky with accepting jobs.3
Unemployment Insurance – An Important Policy
Unemployment benefits are often criticized. Any expansions of UI, such as those during the Covid pandemic, are even more so criticized. The work by CDMS, however, shows how UI expansion in recessions might actually be an optimal policy. This is because people are generally risk averse, which can lead to sub-optimal, albeit correct, decision making. UI is needed to ‘correct’ for that risk aversion and encourage people to make decisions that benefit everyone.4
Moreover, CDMS show us that reducing UI benefits may actually reduce the number of firms willing to offer jobs. That’s because firms understand that employed workers are more fearful of switching jobs given a higher risk of unemployment.
The CDMS paper has also shown us how important it is to really consider people’s behavior. If we were to completely ignore the fact that people take into account the likelihood of getting laid off, our view of UI would be completely distorted and make the program look less beneficial.5
Key Takeaways:
Workers consider job security when changing jobs;
UI encourages job-to-job transitions, as workers are less afraid of unemployment;
Through this channel, UI increases economic productivity and encourages job creation.
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A worker and a firm together generate output that has value. Both the worker and the firm bargain over this output and arrive at a wage. The worker’s wage is higher if it has a higher credible counter offer – or more technically, an outside option. The outside option is the worker’s next best alternative. A firm, in this model, does not have an outside option – it either produces nothing without the worker or gets to produce if the worker is employed.
In the survey, CDMS explicitly asked individuals about their current wages and their own perceptions of the likelihood of being laid off in the next 12 months. Then they asked for the survey respondents to imagine if they faced different job loss probabilities, what would they demand as wages. The survey results appear reasonable, but as always with any surveys – caution is warranted in treating the data as fact.
The current version of the paper does not look at how total output in a recession would change with a change in replacement rate
In an idealistic world, an individual would be able to buy insurance tailored to their risk of losing jobs. However, this would not be possible, as this risk is not really measurable on an individual basis.
I also think this paper is conservative in its results, as it assumes interest rates would not respond to UI expansions. Monetary policy may further boost the positive impact of UI benefits.