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

Purpose – The 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/approach – An 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. Findings – The 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/implications – One 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 implications – This 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/value – The main contribution of this paper is to use an unobserved component model to estimate the degree of inflation synchronization in East African countries.