Economics in a picture
The combined effect of the shocks generated by the pandemic crisis led to a reduction in the euro area inflation in 2020
The pandemic crisis generated supply and demand shocks, with opposite sign impacts on inflation. The reduction in social interaction, whether voluntary or as a result of containment measures, coupled with increased uncertainty, led to lower demand for goods and services, which may have induced firms to lower prices. The mandatory shutdown of some activities and the closing of borders led to disruptions in production and distribution chains, which contracted supply and raised prices. The cost of adapting the functioning of businesses to the pandemic context may also have been transmitted to final prices.
To evaluate the relative impact of these shocks on the euro area inflation, a Bayesian Vector Autoregressive model (BVAR) with sign restrictions aiming to identify demand and supply shocks based on their expected impact on GDP and inflation was estimated. A demand shock moves prices and output in the same direction, while a supply shock moves them in opposite directions. The results suggest significant and predominant impacts of demand shocks, particularly during the second quarter of 2020, which contributed to the reduction of the euro area inflation. Nonetheless and for that same period, important supply shocks (which were stronger than in the past) were also identified.
For more details, see Box 1 “Developments in inflation and the pandemic: demand shocks versus supply shocks“, published in the Economic Bulletin of Banco de Portugal, May 2021.
Prepared by Alexandre Carvalho, Cátia Silva and Sara Serra. The analyses, opinions and findings expressed above represent the views of the authors and not necessarily those of Banco de Portugal or the Eurosystem.
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