Central Banks and the Absorption of International Shocks (1891-2019)

We study how central banks have used their balance sheet to absorb international monetary shocks since the late 19th century, thereby regaining some monetary policy autonomy in a context of financial openness. If the uncovered interest rate parity does not hold, an increase in the leading international interest rate may push up domestic interest rates in both fixed and floating exchange rate regimes. Central banks can partially insulate domestic short-term interest rates from this increase by expanding domestic assets. With a fixed exchange rate, this is in addition to the sterilization of foreign exchange interventions. Accounting for the response of central bank balance sheets to an exogenous international shock sheds light on some puzzling behavior of interest rates and exchange rates across international monetary regimes in history. This study is based on a new monthly dataset of central bank balance sheets, macroeconomic, and financial variables for 23 countries since 1891.