HEALTH CARE INFLATION AND ITS IMPLICATIONS FOR MONETARY POLICY

I. INTRODUCTION For over a decade, rising health spending in the United States has been a major topic of debate. During 2000-2007, nominal health spending grew at an average of 7.5% per year compared with the nominal GDP growth rate of 5.1% per year, and much of the health spending growth was due to health care inflation. (1) In 2013, health spending in real terms comprises almost one-fifth of total real GDP and this share is predicted to exceed 30% by 2050 (Hall and Jones 2007). Despite the growing presence of the health care sector in the economy and an aging population in the United States and around the globe, there are few studies that look at the interaction between health care inflation and monetary policy. This is because in the monetary policy literature the goal of monetary policy is, in part, to stabilize the aggregate price level, instead of sector-level prices. * We thank William A. Branch (Co-Editor) and two anonymous referees for their constructive comments. We also thank the seminar participants at Hitotsubashi University and Kyoto University for providing valuable feedback and discussions. The first author acknowledges support from the PSC-CUNY Research Fund, City University of New York, 2009-2010. Yagihashi: Department of Economics, Old Dominion University, Norfolk, VA 23510. Phone 757-683-3512, Fax 757683-5639, E-mail tyagihas@odu.edu Du: Department of Economics, Old Dominion University, Norfolk, VA 23510. Phone 757-683-3543, Fax 757-6835639, E-mail jdu@odu.edu This paper aims to answer the following questions: (1) are inflation dynamics in the health care sector different from other sectors? (2) If so, how is the effect of monetary policy different in models that separate the health care sector from other sectors? To address the first question, we obtain some stylized facts about health care inflation in the United States using principal component analysis (PC A) and a factor-augmented vector autoregression. We find that during 1980-2013 the volatility of health care inflation is much lower, and the persistence is higher than other services in the personal consumption expenditure (PCE) category. The response of health care prices to an innovation in the federal funds rate is found to be smaller than that of other services. To address the second question, we introduce a dynamic stochastic general equilibrium (DSGE) model with two novel features. On the household side, we include health status in the utility function and distinguish health care demand from the demand for other goods. In the model, health is a "quality of life" indicator. Households can improve their quality of life by combining health spending with leisure. On the supply side, we allow the frequency of price adjustment in health care goods to be lower than regular goods, reflecting an empirical regularity (Bils and Klenow 2004). We show that the model can successfully replicate the low volatility and the high persistence of health care inflation as seen in the data. The main findings are summarized as follows. First, when the model economy is subject to an expansionary monetary policy shock, it yields an amplified response of the equilibrium output and a muted response of the equilibrium inflation in the health care sector relative to the regular goods sector, consistent with our empirical finding. Second, to understand the implication for monetary policy, we compare the impulse responses of our model with those of a two-sector model that does not feature health care. When these models are subject to the same expansionary monetary policy shock, the response of aggregate output is stronger and the response of aggregate inflation is weaker under the health care model. The differences between the two models lie in how households balance health spending and leisure to achieve better health. When health spending increases, health improves, which lowers the marginal utility of health and allows households to work longer hours and produce more output. …