The current Corona virus crisis can be understood as a combination of a supply and a demand shock in the economy. The supply shock results from the shut down of large parts of the economy, which can be simplified by assuming a reduction in the available labor. For the purpose of this question assume that this simply results in a new, lower natural level of output (you don't need to derive or explain this). The demand shock could result from lower consumer confidence - the higher uncertainty about the future causes them to consume less for any level of income they have. Assume that the economy was at the old natural level of output before the shocks occurred. The economy is described by the IS-LM-PC model. Assume that people

have adaptive expectations of the formte=t1.

(a) If the demand shock is more important in magnitude (with respect to the changes in output) compared to the supply shock and there are no other short-run shocks, what would you expect to happen to output and inflation in the economy in the short-run and over time in the transition to the medium run? Explain briefly. Show your analysis graphically.

What would be different if the supply shock was more important in magnitude

than the demand shock? Explain briefly.

Suppose the central bank believes that only the demand shock has occurred. For which of the two previously discussed cases (in the previous two parts) would the central bank learn that this is wrong? Why?