Optimal unemployment insurance in a directed search model

Over recent decades, several economies have experienced changes in the level of aggregate and idiosyncratic volatility. This paper investigates the appropriate labor market policy response to such changes. We introduce unemployment benefits financed by a proportional earnings tax within a model of directed search on the job. The optimal benefit level is hump‐shaped as a function of the level of idiosyncratic risk, and the welfare costs of deviating from the optimum are substantial. In contrast, while the optimal generosity of unemployment insurance—which is pro‐cyclical—declines with the amount of aggregate risk, the welfare costs of deviating are small.