Phillips Curve

The Phillips curve shows an inverse relationship between unemployment and the rate of inflation, especially in the short run. It treats unemployment as an indicator of economic slack: lower unemployment tends to increase wage and price pressures, while higher unemployment tends to weaken them.

How unemployment affects inflation

An expansion of aggregate demand raises production and employment when spare capacity exists. As unemployment falls, labour becomes harder to obtain, workers gain bargaining power, and wages tend to rise faster; firms may pass higher labour costs and strong demand into prices.

• When unemployment rises, weaker demand and reduced wage bargaining generally lower inflationary pressure.
• A movement along the curve assumes that inflation expectations and supply conditions remain broadly unchanged.

Expectations and the time horizon

The expectations-augmented relationship may be written as inflation depending on expected inflation, the gap between actual unemployment and the natural rate of unemployment, and supply shocks.

• If unemployment falls below its natural rate, inflation tends to exceed expected inflation unless favourable supply conditions offset the pressure.
• As expectations adjust, the short-run curve shifts, so the long-run Phillips curve is vertical at the natural rate.
• Keeping unemployment persistently below its natural rate therefore causes accelerating inflation rather than a permanent employment gain.

Limits and relevance to India

The curve is not a fixed or mechanical law. Supply shocks can raise inflation while also reducing output and employment, producing stagflation rather than the usual inverse relationship.

• Food and fuel prices, administered prices, structural unemployment and extensive informal employment can weaken the measured link between unemployment, wages and inflation in India.
• Policymakers therefore examine the Phillips curve alongside the output gap, inflation expectations and supply-side indicators.