UNEMPLOYMENT-INSURANCE AND THE INTERTEMPORAL SUBSTITUTION OF CONSUMPTION AND LABOR SUPPLY

A central feature of modern business cycles is the procyclical pattern of consumption and labor supply. It has proved difficult, however, to construct a market-clearing model that is consistent with this fact and yet retains appealing assumptions and realistic implications. This paper demonstrates the possibility of positive comovements in contemporaneous consumption and labor supply in a model in which the unemployment insurance (UI) replacement ratio links future benefits to previous wage earnings. Specifically, in our model, an increase in the probability of future unemployment unambiguously increases present labor supply and may increase present consumption as well. One testable implication of our analysis is that the positive co-movement of consumption and labor supply is more pronounced in economies with an earnings-based UI system. © 1991 Louisiana State University Press.