The paper explores the scope for a federal unemployment insurance scheme in the euro area. It models a union of atomistic member states that have authority over a wide range of domestic labor-market policies. Member states are faced with idiosyncratic business-cycle shocks, but are prevented from international borrowing.
Labor-market frictions and wage rigidities mean that business cycles are inecient. Federal UI transfers are nanced through a lump-sum tax on member states. For xed local labor-market policies, optimal federal unemployment-based transfers provide full insurance against regional shocks, and smooth the business cycle. If member states can adjust labor-market policies in response, however, optimal federal UI is much less generous, rendering federal UI ineective. Indexation of payouts to past unemployment rates does not address the dynamic incentives to freeride. Federaltransfers can be eective if more political authority is transferred to the federal level: either authority over labor-market policies, or if the federal UI system is structured like an enforceable loan.