Abstract
Traditionally, one major criterion of an optimum currency area has been a high degree of business cycle synchronization. But the optimum currency area literature takes for granted the capacity of the monetary union to conduct an independent monetary policy with an effect that will be stable and homogenous across countries in a region. In this paper, we investigate whether the EAC is an optimum currency area by studying the suitability of a single interest rate and/or monetary aggregates as monetary policy tools to achieve symmetrical effect across countries in the region. We find that there is significant heterogeneity in the speed and magnitude of pass through from central bank policy rates to retail interest rates across countries in the region, which implies that a single policy rate is not a viable monetary policy tool to achieve homogenous effects even in the face of symmetrical shocks. We also find that the money demand functions of Kenya and Tanzania are characterized by the presence of currency substitution with respect to the U.S. dollar. Given the fact that the demand for the monetary union's currency will inherit the behavior of its constituent countries and especially its biggest economy (Kenya), the monetary union will not have monetary aggregates as viable policy tools either. We conclude by noting that the region needs to aim for a low and stable inflation rate to reduce currency substitution and/or needs to increase harmonization of financial markets to increase the similarity of interest pass through before forming a monetary union.