This paper explores the effect of unemployment insurance (UI) on formal job search and effort allocated to a one-person informal firm. I propose a new mechanism that explores the possibility of investing the unemployment benefits in informal production. This mechanism occurs because of two main reasons. First, agents can invest their assets in a production process in the informality, shaping its profitability depending on their investment. Second, unemployment insurance can relieve consumption pressure on the unemployed's assets and decrease the burden of any liquidity constraints, so they can invest in the informal sector rather than consume them. To explore this mechanism theoretically, I develop a finite partial equilibrium model with a dual labor market and liquidity constraints. I find the Effort Allocation Effect (EAE) of the unemployment benefit on the formal job search effort and the informal job effort and present the composition of such an effect in each sector. Moreover, I show under what circumstances the UI will increase the search effort for an informal job and present the mathematical forms under which informal effort increases while the formal one decreases. I also decompose the EAE for both sectors and find that the Effort Allocation Effect in the informality is due only to a liquidity effect.
