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This paper develops a model of equilibrium unemployment with duration‐dependent unemployment insurance (UI) payments. As the government does not observe job offers, there is a moral hazard problem because the option of receiving further UI payments raises the job‐seeker's value of remaining unemployment. Extending the duration of UI payments while reducing the level of payments, to hold total generosity constant, results in higher negotiated wages. Simulations suggest that a generosity neutral switch from a six‐month UI scheme to a one‐year scheme has small effects, but a switch to an indefinite scheme has a large impact on wages and unemployment.

This paper develops a model of equilibrium unemployment with duration-dependent unemployment insurance (UI) payments. As the government does not observe job offers, there is a moral hazard problem because the option of receiving further UI payments raises the job-seeker's value of remaining unemployment. Extending the duration of UI payments while reducing the level of payments, to hold total generosity constant, results in higher negotiated wages. Simulations suggest that a generosity neutral switch from a six-month UI scheme to a one-year scheme has small effects, but a switch to an indefinite scheme has a large impact on wages and unemployment. © The London School of Economics and Political Science 2004. ; Peer Reviewed