Suppose that the Federal Reserve thinks that a stock market bubble is occurring and wants to reduce stock prices. What should it do to interest rates?

As the expected rate of return increases, the demand for investments increases. With an increase in investment demand, the stock prices rise. Thus, an investment’s rate of return is directly related to its price.

To reduce the price of stocks, the rate of returns on stocks will have to be reduced. Controlling the risk premium is not in the hands of the Federal Reserve because it cannot alter the risk premium. However, the Fed can use its monetary policy to control the risk-free interest rate.

The Fed will increase the money supply in the economy, lowering the federal rates and other interest rates on the short-term government bonds. It will reduce the risk-free interest rate, and the expected rate of return will ultimately fall. Hence, the stock prices will cool down.