The author uses an equilibrium model of job matchings with a Nash wage equation to derive the response of wages and unemployment to productivity shock. By endogenizing labor's threat point, he shows that wages absorb fully permanent shocks but only partially temporary shocks. Hence, unemployment responds to perceived temporary shocks but not to permanent shocks.

This paper considers the effects of wage taxes, employment subsidies and unemployment benefits in a simple model of equilibrium search. Unemployment is determined by the equality of job matchings and job separations, job vacancies are determined by a zero-profit condition and wages by a Nash bargain between the meeting firm and worker. I show that marginal wage taxes influence the firm's and worker's equilibrium sharing rule, whereas employment subsidies and unemployment benefits influence only the surplus shared. Hence, tax-financed subsidies reduce wages and raise employment and vacancies, whereas tax-financed unemployment benefits raise wages and reduce employment and vacancies.

This paper argues that if the disincentive effects of unemployment insurance result from higher reservation wages, they may be eliminated by financing benefits with a progressive income tax. The result is obtained within an equilibrium model with stochastic job matchings. An optimal tax formula is derived for a linear income tax, and shown to imply that the average tax rate should increase faster with income the higher the level of UI benefits relative to other government expenditure. In some cases optimal financing may require the subsidization of low-wage jobs.