Supply and demand and the COVID-19 shock

COVID-19 has had clear supply effects: quarantines, closed factories,supply chain disruptions and impaired mobility obviously affectproduction. The effects on demand are more difficult to gauge but itis critical from an economic policy point of view to get a sense of thembecause we have more confidence about how to deal with demand(through monetary and fiscal tools) than with supply deficiencies.Changes in real goods prices can indicate whether COVID-19 iscausing major demand effects. Specifically, if aggregate supply effects dominate demand effects, we should see prices going up as activitygoes down, in a kind of repeat of the stagflation of the 1970s. At thattime, central banks were in adilemma about whether to increase ratesto fight inflation or to reduce rates to support economic activity. If prices remain largely unchanged, we can conclude that aggregate demandhas also been substantially negatively affected by the spread of thevirus.

Task:

Use the AD-AS model, including your own diagram/s, to explain whylooking at prices would be a useful way to compare the relative magnitudes of the supply shock and demand shock.