The COVID-19 pandemic, and associated public health responses such as shutdowns, can be thought to include both a negative supply shock, and a negative demand shock.

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:

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.