Phillips Curve

The original Phillips Curve was derived empirically by New Zealand economist A.W. Phillips in 1958, based on nearly a century of UK data showing that wage inflation and unemployment moved in opposite directions. The logic was intuitive: when unemployment was low, workers had stronger bargaining power, driving up wages and thus costs, which fed into broader price inflation. When unemployment was high, wage bargaining power was weak, keeping wages and prices stable.

Policymakers in the 1960s and 1970s interpreted the Phillips Curve as a stable menu of choices — governments could choose a point on the curve, trading off more inflation for less unemployment or vice versa. This view was discredited by the stagflation of the 1970s, when both inflation and unemployment rose simultaneously, appearing to shift or destroy the curve. Economists Milton Friedman and Edmund Phelps had separately predicted this breakdown, introducing the concept of the "natural rate of unemployment" (NAIRU — Non-Accelerating Inflation Rate of Unemployment): they argued that attempts to push unemployment below its natural rate would accelerate inflation without permanently reducing unemployment, as workers adjusted their expectations upward.

The modern, expectations-augmented Phillips Curve incorporated inflationary expectations as a key variable: current inflation depended on both the unemployment gap (actual vs. natural rate) and expected future inflation. If expectations were well-anchored near the central bank's target, supply shocks could cause temporary inflation without spiraling higher. If expectations became unanchored (as in 1970s USA), inflation could persist and accelerate. This was the intellectual basis for inflation targeting as a framework for managing expectations.

In the Indian context, the direct application of the Phillips Curve was complicated by the structure of the labour market. India's formal unemployment rate, as measured by the PLFS (Periodic Labour Force Survey), did not capture the full picture of underemployment, informal sector employment, and disguised unemployment in agriculture. India's unemployment rate moved within a relatively narrow band even as inflation varied considerably, making the classic Phillips Curve less empirically robust as a guide for Indian monetary policy.

Nevertheless, the RBI's MPC reports and academic research on Indian monetary policy referenced the output gap — the difference between actual and potential GDP — as a domestically relevant analogue to the unemployment gap in the Phillips Curve framework. When the output gap was positive (economy running above potential), inflationary pressures were expected to build. When the output gap was negative (actual output below potential, as during COVID-19), demand-side inflationary pressures were expected to be muted even if supply shocks drove headline inflation higher. This framework shaped the MPC's assessment of whether inflation was driven by transient supply factors or more persistent demand factors.