Example: 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 paid to Michigan auto makers falls. Factories close and jobs are lost. These poorer workers see the relatively higher wages in the rest of the US and move to, let’s say Texas, where there are good oil manufacturing jobs. Capital also moves as the machines that were used to make the cars are moved down to Texas and used to make gasoline. The Federal Government starts collecting fewer taxes from Michigan as incomes fall and starts spending more money in Michigan on welfare (which it collected from those making money in Texas). In the end the market is balanced internally and the government spending blunts the effect of the asymmetric shock. The problem of unresponsive monetary policy is lessened by the fiscal transfers.