Balance sheet functioned as monetary policy tool across 20th century

Examining 104 years of Banca d'Italia data from its foundation to 1998, the study applies VAR models to trace the evolution of the central bank's balance sheet.

The empirical analysis demonstrates that the balance sheet systematically responded to macroeconomic conditions, contracting in reaction to rising inflation and exchange rate depreciations while expanding following increases in real output, government debt, and international trade.

Conversely, exogenous balance sheet expansions were followed by significant increases in real output, trade, and inflation, alongside exchange rate depreciations.

These dynamics closely mirror both conventional monetary policy instruments and recent unconventional measures, indicating that the balance sheet operated as an active policy tool long before modern quantitative easing.

Using a rolling VAR approach to account for structural breaks across the 20th century, the findings show that balance sheet effectiveness remained consistent across markedly different economic phases.

While policy interest rates became the primary tool for controlling inflation internationally from the early 1980s onward, the central bank balance sheet continued to operate alongside the policy rate rather than losing its policy function.

The study suggests that balance sheet policies proved effective in both normal times and periods of economic distress, driven partly by the absence of modern, developed financial and money markets during much of the century.