Inflation convergence and currency unions: the case of the East African community

Abstract

PurposeThe purpose of this paper is to investigate inflation convergence within the East African Community (EAC) as it aspires to become a currency union.Design/methodology/approachAn unobserved dynamic factor model was used to decompose the variation in inflation into a component that is common across the countries in the EAC region and a component that is country specific. Convergence was measured by the percentage of variation in inflation that is common across countries.FindingsThe estimated results from the dynamic factor model for the pre‐EAC Treaty (1981:3 to 2000:2) period and post‐EAC Treaty (2000:3 to 2009:1) period suggest that the percentage variation in inflation in the EAC that is explained by the common regional component increased significantly during the post‐Treaty period.Research limitations/implicationsOne of the limitations of this paper is that it does not address the mechanism through which the convergence in a currency union is achieved. Future research should try to examine the link between convergence and different macroeconomic policies.Practical implicationsThis paper suggests that the push towards forming a currency union in East Africa has led to a greater degree of inflation synchronization across different countries in the region.Originality/valueThe main contribution of this paper is to use an unobserved component model to estimate the degree of inflation synchronization in East African countries.