Health Shocks and Policy Evaluation∗

The medical sector is a large and growing part of the US economy, and expenditures on medical care are funded in large part by the government. As a result, understanding the effects of the policies which finance medical expenditures is of critical importance. In order to understand the effects of these policies, such as Medicare and the recently passed health care act, it is critical to understand the nature and distribution of health shocks. The existing literature largely uses health expenditure shocks as a proxy for health shocks in order to abstract from modeling the medical decision, and this assumption has strong implications for the effects of policy. In this paper, I develop a structural model of the accumulation and depreciation of health capital over the life cycle. In this model, individuals accumulate health capital through medical consumption, and a health shock is a shock to the depreciation rate of health capital. To demonstrate the utility of this framework, I calibrate the model to be consistent with various features of the US economy, and evaluate a simple policy changes in which a reduction in the co-payment rate for medical care for sick individuals is financed by a lump-sum transfer. In this model, in contrast to a model with exogenous medical expenditures, I find that these policies reduce welfare.