The Prospects for the East African Monetary Union: An Empirical Analysis

Abstract

This thesis operationalizes the theory of optimum currency areas, which describes the preconditions (criteria) that countries must fulfill prior to forming a monetary union. In light of the different dimensions of the theory that are examined, the empirical findings from the four papers in this thesis seem to favor forming a monetary union among East African Community (EAC) partner states. Hence, the findings are important for EAC policymakers, as they decided to participate in a monetary union by 2024. The first paper uses a gravity model to determine to what extent membership in the EAC has affected intraregional trade. One common argument is that if there is not much trade between EAC member countries, there is no interest in forming a monetary union. The paper implements the fixed effect filter estimator, which uses a two-step approach and has better performance than the standard fixed effect estimator. The empirical findings in this paper show that EAC membership has a positive and significant effect on intra-trade among member countries. The second paper investigates business cycle synchronization and core-periphery patterns. Greater synchronization is needed for an easy transition towards monetary union. Unlike previous studies, this paper uses wavelet decomposition, a powerful tool for analyzing the comovement of business cycles. It is found that business cycle synchronization is more significant for Kenya, Tanzania, and Uganda, the countries that also form the core of the East African Monetary Union. The link between business cycle synchronization and trade intensity among EAC countries is established in the third paper. This analysis is relevant, as it is associated with the hypothesis of the endogeneity of the optimum currency area criteria, whereby a monetary union among member countries is predicted to increase trade among them, which, in turn, may lead to more synchronized business cycles. The empirical findings show that trade intensity among the considered countries has indeed led to more synchronized business cycles, suggesting that monetary union among EAC countries may be beneficial. Moreover, the fourth and last paper uses a similarity index and a rank correlation measure, Kendall’s tau, to investigate the movement of inflation rates among EAC countries. The results show that changes in inflation have become more similar over time and that there are high correlations between EAC countries. This paper also investigates the convergence in inflation rate levels among the EAC countries. It is found that these levels have tendency to converge. These findings favor the formation of a monetary union among these countries.