Question

7.During his confirmation hearing in 1979 before the Senate Banking Committee, the soon-to-be Fed chairman Paul Volcker pledged to make fighting inflation the top priority of the Federal Reserve. Suppose the Federal Reserve had announced in 1980 an inflation target of 2% and everyone in the economy had believed that this announcement is credible (i.e. that the Federal Reserve manages to reduce inflation to 2% almost immediately), then ___________

		inflation expectations would have rapidly declined and the Federal Reserve would not have had to increase interest rates by as much as it did in order to get inflation to decline.
		the high oil price of the late 1970s and early 1980s would have had no effect on the U.S. economy.
		inflation in the 1980s would have fallen even if the output gap had remained positive.
		the Federal funds rate would not have been constrained by the zero lower bound.

Answer 1

................... then inflation expectations would have rapidly declined and the Federal Reserve would not have had to increase interest rates by as much as it did in order to get inflation to decline.

When there is credibility, then the inflation target can be achieved by anchoring people's expectations about both current and future inflation rates. Thus, the Fed would not have to increase the interest rate too much to fight off inflation.