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 affect production[1]. The effects on demand are more difficult to gauge

but it is critical from an economic policy point of view to get a sense of them because 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 is causing major demand effects.

Specifically, if aggregate supply effects dominate demand effects, we should see prices going up as

activity goes down, in a kind of repeat of the stagflation of the 1970s. At that time, central banks

were in a dilemma about whether to increase rates to fight inflation or to reduce rates to support

economic activity. If prices remain largely unchanged, we can conclude that aggregate demand has

also been substantially negatively affected by the spread of the virus.

Your Task:

Read the excerpt above (you may want to read the full article for context or for your own

interest, but you do not need to refer to the additional content there).

Use the AD-AS model, including your own diagram/s, to explain why looking at prices would

be a useful way to compare the relative magnitudes of the supply shock and demand shock.