Phillips curve

Topic: Inflation and Index Numbers: CPI, WPI, IIP and the Deflator · NCERT: Beyond NCERT

Meaning

The Phillips curve is a curve that shows a short-run inverse relationship between inflation and unemployment. When unemployment is low, inflation tends to be high, and when unemployment is high, inflation tends to be low. The original 1958 study measured wage inflation. Later versions use price inflation.

It matters because it shows the basic choice a central bank faces. Pushing jobs up in the short run can push prices up. In the long run, once people expect the higher inflation, the trade-off disappears.

Expectations-augmented Phillips curve (standard textbook form): π = πᵉ − β(u − u*)

• π = actual inflation
• πᵉ = expected inflation
• u = actual unemployment
• u* = natural rate of unemployment
• β = how strongly inflation reacts to slack in the economy (the slope of the curve)

Explanation

How the original curve works (short run)

• A.W. Phillips (1958) studied UK data. He found that wage inflation was high when unemployment was low, and low when unemployment was high. Phillips was a New Zealand economist [1].
• Why the curve slopes downward:
• When unemployment is low, firms compete for the few workers who are free.
• Workers can ask for bigger wage rises.

• Firms pass these higher wage costs on to buyers, so prices rise faster.

• The link to excess demand (total demand is larger than what the economy can produce at full employment): output cannot rise any more, so prices rise instead.

• Illustrative trade-off (the numbers are only an example):

Point on curve	Unemployment	Inflation
A	8%	2%
B	5%	5%
C	3%	9%

• Moving from A to C "buys" 5 points less unemployment. The price is 7 points more inflation.

• How the curve was read in the 1960s: governments treated it as a fixed menu of choices. They thought they could keep unemployment low for ever by accepting a little more inflation.

The Friedman–Phelps critique: expectations change everything

• Inflation expectations: the rate of inflation that workers and firms believe will happen. They build this belief into wage deals and prices.
• The argument, step by step:
• The government pushes demand up. Prices rise by 5%, but workers still expect 2%.
• For a while the real wage (the money wage adjusted for prices) falls. Hiring becomes cheaper, so unemployment falls.
• Workers later expect the higher inflation and ask for matching wage rises.

• Real wages return to normal. Unemployment goes back to its old level. Only the higher inflation stays.

• Result: the trade-off vanishes once expectations adjust. Each new attempt to hold unemployment low needs even more inflation.

• Worked example: πᵉ = 4%, u* = 6%, β = 0.5.
• If u = 4%: π = 4 − 0.5(4 − 6) = 4 + 1 = 5%.
• Next year workers expect 5%, so πᵉ = 5. If u is still 4%: π = 5 + 1 = 6%. Inflation keeps accelerating.
• If u = u* = 6%: π = πᵉ. Inflation stays steady at whatever level people expect.

Short-run vs long-run curve

• Short-run Phillips curve: slopes downward. Each curve is drawn for one level of expected inflation.

• When expectations rise, the whole short-run curve shifts upward.

• Long-run Phillips curve: vertical at the natural rate of unemployment. This is the unemployment that remains when the economy runs at its normal long-term level. It comes from:

• job-search time (frictional unemployment)
• skill or location mismatch (structural unemployment)

• It does not come from weak demand.

• There is no lasting trade-off. In the long run, higher inflation cannot buy lower unemployment.

• NAIRU (non-accelerating inflation rate of unemployment) is the lowest unemployment rate the economy can hold without inflation speeding up.
• Unemployment below NAIRU makes inflation rise year after year.
• The IMF treats the natural rate and NAIRU as two names for the same idea. At this rate there is no upward or downward pressure on inflation [1].
• NAIRU can shift because of technological advances and demographic shifts (changes in the age make-up of the population). Many economists believe the 1990s technology boom lowered it [1].

What moves us along the curve vs what shifts it

Shock	Prices	Output / jobs	Phillips-curve movement
Demand rises (excess demand)	↑	↑ (short run)	Movement along the curve
Supply falls (oil, drought)	↑	↓	Curve shifts up, with a risk of stagflation

• The 1970s oil shocks broke the simple curve:
• Oil prices jumped, so costs rose for almost every firm.
• Aggregate supply shifted left, so prices rose and output fell together.

• Inflation and unemployment rose together, which the simple curve could not explain. This is stagflation.

• Stagflation remains a risk after big supply shocks, such as the rise in energy and food prices in 2022.

In India

• The curve is flat or weak when drawn with unemployment data. There are two reasons:
• Most workers are informal. They have no written contracts and no wage indexation (automatic wage rises linked to prices). So wages and unemployment are poorly measured. Disguised unemployment (more people on a job than it needs, so some add nothing to output) hides the true slack.

• Much of India's inflation is supply-driven food inflation. It comes from monsoon failure, crop damage and MSP (minimum support price, the price at which the government promises to buy certain crops). None of this is linked to how tight the labour market is.

• So the RBI uses the output gap instead of unemployment to measure demand pressure.

• Output gap (%) = (Actual GDP − Potential GDP) ÷ Potential GDP × 100.
• Potential GDP is the output the economy can produce without inflation speeding up. It is the output version of NAIRU.
• Example: actual GDP ₹300 lakh crore and potential GDP ₹295 lakh crore give a gap of about +1.7%. A positive gap means demand pressure, so the RBI is likely to hold or raise the repo rate (the interest rate at which the RBI lends money to banks for a short time).

• Potential output cannot be seen directly. RBI research says it should be the output that is consistent with low and stable inflation [4].

• What RBI research finds:

• Behera, Wahi and Kapur (2017) used state-level CPI-IW data for 2007–2016 and CPI-C data for 2011–2016. They found that a conventional Phillips curve holds for both core and headline inflation [2].
  • Output-gap coefficient: 0.38–0.49 for core and 0.35–0.49 for headline inflation [2].
  • Demand pressure affects core inflation (inflation without food and fuel) more than headline inflation [2].
  • Each 1 percentage point rise in food inflation adds about 15–25 basis points to core inflation (100 basis points = 1 percentage point) [2].
  • Good rainfall eases price pressure, while MSP increases harden headline inflation [2].
  • The curve is flatter for CPI-C than for CPI-IW [2].

• RBI Bulletin (November 2021): India's Phillips curve is convex (non-linear) [3].

  • It is flat when the output gap is low or negative, meaning the economy is running below capacity.
  • It steepens when the output gap is large and positive, meaning the economy is overheating.
  • Policy meaning: slack does little to pull inflation down, but overheating pushes it up fast.

• Link to inflation targeting:

• The target is 4% CPI inflation, with an upper limit of 6% and a lower limit of 2%. It was first notified for 5 August 2016 – 31 March 2021 [5][6].
• It was retained in the reviews of 31 March 2021 and 25 March 2026. The second review covers 1 April 2026 – 31 March 2031 [5].
• A six-member Monetary Policy Committee (MPC) sets the repo rate [5].
• The band lets the MPC recognise short-run trade-offs between inflation and growth, which is a Phillips-curve idea. It still aims at 4% over the business cycle [7].

Don't confuse with

• NAIRU / natural rate: this is one point (an unemployment rate). The Phillips curve is the relationship between inflation and unemployment. The long-run Phillips curve is a vertical line drawn at NAIRU. NAIRU is not zero unemployment.
• Stagflation: inflation and unemployment rise together because of a supply shock. That is an upward shift of the Phillips curve, not a movement along it.
• Misery index: this is inflation rate + unemployment rate, a rough measure of hardship. It adds the two numbers. The Phillips curve shows how they trade off against each other.
• Output gap: this measures demand pressure through GDP, not jobs. The RBI uses it in its version of the Phillips curve because Indian unemployment data are weak.

Prelims Hooks

• A.W. Phillips (1958) used UK data to link wage inflation with unemployment. Phillips was a New Zealand economist [1].
• Short-run Phillips curve slopes downward. Long-run Phillips curve is vertical at the natural rate, so there is no permanent trade-off.
• Friedman–Phelps critique: the trade-off disappears once inflation expectations adjust. Higher expectations shift the short-run curve up.
• Trap: a demand rise causes a movement along the curve. A supply shock such as the 1970s oil shocks shifts it up and causes stagflation.
• RBI research uses the output gap, not unemployment. Demand pressure hits core inflation more than headline inflation [2]. India's curve is convex: flat when the output gap is negative and steep when it is large and positive [3].
• The ±2% band around the 4% CPI target reflects short-run Phillips-curve trade-offs [7]. The target is retained up to 31 March 2031 [5].

Mains Points

• Why the RBI cannot steer by unemployment data:
• Informal jobs and disguised unemployment hide the true slack, and a large share of inflation comes from food supply shocks.
• So the RBI tracks the output gap and core inflation.

• Supply-side tools such as buffer stocks, import duties, supply-chain reforms and restraint on MSP-led price pressure work better on food prices than repo-rate changes.

• Food inflation shifts India's Phillips curve:

• It spills into core inflation (about 15–25 basis points per point) [2].
• It also raises household inflation expectations, which shifts the short-run curve up.

• This is why the RBI cannot fully "look through" long spells of food inflation.

• Inflation targeting follows Phillips-curve logic:

• The ±2% band accepts short-run trade-offs between output and inflation.
• The fixed 4% anchor reflects the vertical long-run curve: in the long run, inflation cannot buy growth.
• After supply shocks (the 1970s, 2022), aggressive rate hikes alone can deepen the slump. Targeted fiscal support and fixes to supply work better.

Related concepts

• Long-run Phillips curve
• NAIRU
• Stagflation
• Misery index

Read more

• Inflation and unemployment: the Phillips curve, NAIRU and stagflation