Note: For answering all questions in this Quiz, keep in mind that a demand shock is a change in the equilibrium real GDP determined by the crossing points of IS and LM curves. A supply shock is a change in the production capacity. When the change is positive, the shock is called favorable. When the change is negative, the shock is called adverse. The magnitude of a demand shock is the absolute value of the change in equilibrium real GDP, and the magnitude of a supply shock is the absolute value of the change in the production capacity.

1. In 2019, the European economy was in a long-run equilibrium. In 2020, the outbreak of COVID-19 made it costly for many firms in Europe to produce, which led to massive production cuts and layoffs. At the same time, many European households that faced job losses, income reductions, and increased uncertainty curtailed their consumption. Also, the pandemic prevented households to purchase some of the goods and services that they would have bought if the risks of exposure to COVID-19 were absent. Finally, investment expenditure declined as businesses in Europe wondered when the economy would recover. These observations suggest that as a result of the pandemic, the European economy must have experienced

a. a combination of favorable supply and demand shocks.

b. a combination of adverse supply and demand shocks.

c. a favorable supply shock combined with an adverse demand shock.

d. a favorable demand shock combined with an adverse supply shock.

2. In the context of Question 1, we know that the European economy was in a long run equilibrium in 2019 and experienced a sharp reduction in GDP in 2020. Also, the rate of inflation that had been running at about 1% in 2019 turned negative in 2020. These observations imply that

a. The magnitudes of the demand and supply shocks must have been equal.

b.The magnitude of the supply shock must have been larger than the magnitude of the demand shock.

c. The magnitude of the demand shock must have been larger than the magnitude of the supply shock.

d. The information provided is insufficient to compare the relative magnitudes of the demand and supply shocks.

3. In the context of Questions 1 and 2, the European Union has been developing a fiscal stimulus package worth 750 billion. That package is likely to go into effect later in 2021. If at that time the pandemic situation eases and supply and demand shocks of 2020 are fully reversed, what would happen to inflation and GDP growth in Europe later in 2021 as compared to the situation in 2020?

a. Both inflation and GDP growth will rise.

b. Both inflation and GDP growth will remain low.

c. Inflation will rise, but GDP growth will stagnate.

d. GDP growth will rise, but inflation will remain negative.