Consider a union of atomistic member states, each faced with idiosyncratic business-cycle shocks. Private cross-border risk-sharing is limited, giving a role to a federal unemployment- based transfer scheme. Member states control local labor-market policies, giving rise to a trade-off between moral hazard and insurance. Calibrating the economy to a stylized European Monetary Union, we find notable welfare gains if the federal schemes payouts take the member states past unemployment level as a reference point. Member states control over policies other than unemployment benefits can limit generosity during the transition phase.
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