Unemployment Insurance in Macroeconomic Stabilization with Bounded Rationality

Abstract

We propose a flexible semi-parametric model of beliefs about macroeconomic outcomes that nests rational expectations, shallow reasoning, cognitive discounting, and adaptive learning among others. Under some restrictions on heterogeneity in beliefs, our framework is tractable in general equilibrium models with rich microeconomic heterogeneity. As an application, we study the power of state-dependent unemployment insurance (UI) in stabilizing short-run fluctuations. Managing expectations is key in this application because higher UI generosity raises consumption, partly, by reducing precautionary saving. If the policy is implemented as a contingent rule that indexes benefits to the unemployment rate, households have to forecast it to anticipate the policy stance. First, we quantify beliefs about the unemployment rate using systematic forecast errors from the Survey of Professional Forecasters. Second, we assign the estimated model of belief formation to households in a quantitative Heterogeneous Agent New Keynesian model with search frictions. We find large efficiency loss, in terms of output stabilization, due to imperfect anticipation of higher benefits.