We incorporate financial frictions and
extend the standard new Keynesian model into a small open economy setting. We
estimate the model on Sri Lankan data. As adverse financial market shock generates
an undesirable fall in household consumption, the central bank should continue
to respond to an adverse financial market shock that increases the credit
spread and thereby reduce aggregate demand in the economy.

It
is well established in the literatures that maintaining macroeconomic stability
is an essential prerequisite for robust and sustainable growth. The financial
sector perceived to be factors which contribute to the smooth performance of
the economy. Stable financial system promotes efficiency by facilitating
transaction payments and the management of risk (Svensson, 2012). However,
policy uncertainty created by financial instability affects growth through the
volatility of returns on investment and misallocation of resources as price
signals become distorted (Fischer, 1993; and Fatas and Mihov, 2013). Financial
markets are considered to be particularly relevant to the investment decision.
In the absence of strong financial system, the central bank has an incentive to
depart from full price stability in response to productivity shocks (Kolasa and
Lombardo, 2011). This environment led many central banks in both developed and
developing economies to reconsider their monetary policy reaction function in
response to the changes in financial conditions.

This study seeks to focus particularly
on the issues related to the impacts of financial frictions on business cycle
dynamics by seeking answers to following research questions.

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How important are financial market
frictions for the business cycle dynamics of a small open economy? What are the quantitative effects of
financial shocks on investment, output and the path of interest rates
determined by the Central Bank of Sri Lanka (CBSL)?How optimal monetary policy changes with
the financial frictions? 

The paper provides an additional insight
by taking an analytical approach to the above research questions in a New
Keynesian economy with financial friction. The findings of the study will help
to understand whether financial frictions generate tradeoff between output and
inflation stabilization. Further, it helps to examine how the welfare function
has been affected by volatility in inflation, output gap and frictions in the
financial market. Hence, by seeking answers for above research questions, the
study clearly provides fresh theoretical insights and empirical evidence to
policy makers regarding the impact of financial frictions on business cycle
dynamics, and thereby provides a necessary evidence base for extracting policy
recommendations in relation to financial variables in future.

This study has three specific objectives
as follows;

Examine the role of financial market
frictions on business cycle dynamics of a small open economy of Sri Lanka.Investigate the quantitative impacts of financial
shocks on investment, output and the interest rates in the case of Sri Lankan
economy.Analyse optimal monetary policy for a
small open economy from an empirical perspective.

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