The Impact of Unemployment Insurance and Unsecured Credit on Business Cycles

Abstract: How does unsecured consumer credit impact the effectiveness of unemployment insurance (UI) in insuring households against idiosyncratic and aggregate risk over the business cycle? The answer depends on whether credit and UI act as complementary or substitutable forms of consumption insurance for households. Using a real business cycle model with frictional labor markets and defaultable debt, I find that unsecured credit amplifies the welfare gains of a policy that extends the duration of UI during recessions. UI extensions mitigate the rise in the default risk premium of unsecured credit during recessions, which allows households to better smooth consumption over the business cycle.