The role of a central bank during a bubble phase has been widely debated in the past. While some argue that monetary policy tools should not be used to prick a bubble in the economy, others argue that using monetary policy tools to prick asset bubbles early in their development can benefit the economy in the long term before it becomes too big and poses systemic risk to even the real sectors.
A central bank can use monetary policy to burst a developing bubble in the economy by increasing the policy interest rate. This would cause the yields of treasury bonds to increase. Market valuation most commonly relies on Gordon Growth model to value listed companies. An important factor in this model is the cost of equity.
As the interest rate increases, causing an increase in the yields of treasury bonds, the risk free rate also increases. Cost of equity is generally calculated using CAPM equation. As risk free rate would increase, the cost of yield would also go up (Investopedia).
A higher cost of equity would then drive down the valuations of companies, causing the overheated economy to slow down. As the valuations become lower, it will prompt a short term selling spree in the market, which would then stabilise the stocks around the new valuations.
Some economists argue that this way of slowing down the economy temporarily for a short duration is a better way of handling a bubble in the economy as the downward movement in stock prices is till the new or revised valuation as compared to continued selling in case of bubble burst later in the cycle (Spicer, 2015).
On the other hand, there are some economists who argue that using interest rates to prick a bubble can be detrimental to the long term health of the economy, hurting some key sectors and driving up unemployment rates (Spicer, 2015).
References
Investopedia. Gordon Growth Model. Investopedia. Retrieved from http://www.investopedia.com/terms/g/gordongrowthmodel.asp.
Spicer, J. (2015). Prick asset bubbles with rates? Fed officials split. Reuters. Retrieved from http://www.reuters.com/article/us-usa-fed-stability-idUSKCN0RW1VG20151002.
