Narrow Results

The East African Community’s (EAC) economic integration has gained momentum recently, with the EAC countries aiming to adopt a single currency in 2015. This article evaluates empirically the readiness of the EAC countries for monetary union. First, structural similarity in terms of similarity of production and exports of the EAC countries is measured. Second, the symmetry of shocks is examined with structural vector auto-regression analysis (SVAR). The lack of macroeconomic convergence gives evidence against a hurried transition to a monetary union. Given the divergent macroeconomic outcomes, structural reforms, including closing infrastructure gaps and harmonizing macroeconomic policies that would raise synchronization of business cycles, need to be in place before moving to monetary union.

I develop a behavioral macroeconomic model in which agents have cognitive limitations. As a result, they use simple but biased rules (heuristics) to forecast future output and inflation. Although the rules are biased, agents learn from their mistakes in an adaptive way. This model produces endogenous waves of optimism and pessimism (“animal spirits”) that are generated by the correlation of biased beliefs. I identify the conditions under which animal spirits arise. I contrast the dynamics of this model with a stylized DSGE-version of the model and I study the implications for monetary policies. I find that strict inflation targeting is suboptimal because it gives more scope for waves of optimism and pessimism to emerge thereby destabilizing output and inflation.