Example: Not an Optimal Currency Area
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Michigan is a part of the currency union of the United States and thus shares the same currency with the rest of America (the dollar). Assume that Americans no longer want gas guzzling SUVs made in Michigan so they stop buying them. As a result, there is a negative aggregate demand shift in Michigan. Assume that the rest of the country’s manufactures do not experience the same demand shift. As demand falls in Michigan, the price of SUVs as well as the wages received by auto workers in Michigan falls. Factories close and jobs are lost. Without labor mobility the workers stay where they are and remain unemployed. In addition, without capital mobility, the machines in the closed factories remain idle. Without any exchange rate adjustment Michigan remains in a recession. The Michigan government collects fewer taxes as incomes fall and starts to spend more money on welfare payments (automatic stabilizers). This leads to a budget deficit. Union-wide monetary policy will not be responsive to Michigan’s problems because the shock is asymmetric and the situation worsens.