The measurement of liquidity and optimal monetary policy response in a financial market in development: the case of Paraguay

Abstract

This paper explains the relationship between monetary policy decisions and the liquidity indicators. To this end, a Taylor Rule is estimated and transitory deviations from the rule are related to a selected liquidity indicator. Results suggest that liquidity in the Paraguayan economy is intimately linked with how loose or tight monetary policy is relative to a Taylor Rule benchmark. Historical data for Paraguay has shown that high (low) liquidity in the financial system is correlated with negative (positive) Taylor residuals.