Employment, the Phillips Curve and Price Stability in India: Why Monetary Policy Needs a Stronger Signal of Economic Activity…..

 Introduction

Price stability is rightly the primary objective of monetary policy because persistently high and volatile inflation erodes purchasing power, distorts savings and investment decisions, redistributes income unpredictably and eventually damages sustainable growth. Yet an exclusive focus on inflation can become incomplete if monetary policy does not adequately observe the labour market through employment, unemployment, labour-force participation, wages and hours worked. The crucial point is that inflation is not produced independently of economic activity: it emerges from the interaction of aggregate demand, productive capacity, wages, expectations, imported costs and supply constraints. Employment therefore provides an important real-economy signal about whether demand is weak, balanced or excessive relative to available productive capacity. India’s flexible inflation-targeting framework explicitly gives primacy to price stability while requiring monetary policy to keep growth in mind, with a 4 per cent CPI target and a tolerance band of 2–6 per cent. The Reserve Bank itself recognises that monetary policy affects inflation through aggregate demand and that output and employment stabilisation remain relevant even when price stability is the formal objective. ([Reserve Bank of India][1]) The central debate, therefore, is not whether RBI should abandon inflation targeting for employment targeting, but whether employment and unemployment are being given sufficient analytical weight to identify the underlying state of economic activity before inflationary or disinflationary pressures become visible in headline prices.

 

Theoretical Foundation

The original Phillips curve established an empirical relationship between unemployment and wage inflation, suggesting that tighter labour markets could generate stronger wage growth and higher inflation while weak employment conditions could moderate wage pressures. The modern expectations-augmented Phillips curve subsequently transformed the interpretation: there may be a meaningful short-run trade-off between inflation and unemployment, but there is no permanent long-run trade-off because workers and firms eventually adjust their inflation expectations. Friedman and Phelps therefore shifted attention from a simple inflation-unemployment choice toward the natural rate of unemployment and expectations. In the New Keynesian framework, the relationship is expressed more broadly through the output gap: when demand exceeds potential supply, firms face capacity constraints, labour becomes scarcer, wages and prices tend to rise, and inflation can become persistent; when demand is below potential, unemployment and unused capacity increase and inflationary pressure generally weakens. The RBI itself describes its analytical framework in similar terms, noting that its Quarterly Projection Model incorporates a Phillips curve linking core inflation to the output gap, expected inflation, the real exchange rate and food and fuel prices. Its research also finds that the Indian Phillips curve may be relatively flat when the output gap is negative but becomes considerably more responsive as the positive output gap becomes large. ([Reserve Bank of India][2]) This is important because a low unemployment rate does not automatically mean that inflation must immediately accelerate, just as a modest unemployment rate does not prove that the economy is operating at full capacity. The composition of employment, labour-force participation, productivity, hours worked, wages and the willingness of firms to hire all matter.

 

Why Unemployment Matters Even Under an Inflation Target

Employment is important to monetary policy because it is one of the clearest observable indicators of whether aggregate demand is translating into actual utilisation of economic resources. GDP growth can remain strong while employment generation is weak if productivity gains, capital intensity or particular sectors account for much of the expansion. Conversely, employment can increase without generating significant inflation if labour supply is expanding rapidly, productivity is improving or substantial spare capacity remains. This makes unemployment and labour-force participation complementary rather than competing indicators of inflation. A falling unemployment rate accompanied by rising participation and rising real wages may indicate genuine strengthening of economic activity. A falling unemployment rate accompanied by falling participation, low-quality work or stagnant real wages may tell a very different story. Similarly, a low aggregate unemployment rate can conceal substantial underemployment, educated unemployment, youth unemployment, regional disparities and involuntary movement into low-productivity informal employment. The Indian labour market therefore requires more than a single unemployment number. The latest annual PLFS data show that the unemployment rate under usual status declined from 5.0 per cent in 2023 to 4.9 per cent in 2024, while the 2025 annual report put the labour-force participation rate for people aged 15 and above at 59.3 per cent, broadly stable from 2024. The 2025 report also showed that regular wage or salaried employment increased to 23.6 per cent of workers from 22.4 per cent in 2024. ([MOSPI][3]) These numbers are encouraging, but they should not be interpreted mechanically as evidence that the economy has reached full employment or that monetary policy can safely ignore labour-market slack.

 

The Indian Policy Framework and the Missing Signal

India’s monetary-policy regime is not formally blind to employment. The amended RBI Act states that the primary objective is to maintain price stability while keeping growth in mind, and the flexible inflation-targeting framework deliberately combines an inflation objective with consideration of growth. ([System Health][4]) The problem is more subtle: employment is not the central operational signal around which policy communication is organised. Inflation, inflation expectations, liquidity, credit, output growth and financial conditions receive substantial attention, while the labour market is often treated as one among several secondary indicators. This can create an information problem. Inflation is a lagging and noisy indicator of demand conditions, particularly in India because food, fuel, weather, administered prices, imported commodities and exchange-rate movements can dominate headline CPI. Employment, vacancies, wages and participation can sometimes reveal the direction of underlying demand earlier. If unemployment is persistently elevated while inflation is being pushed down primarily by supply improvements, imported disinflation or favourable food prices, an overly restrictive monetary stance could unnecessarily suppress consumption, investment and job creation. Conversely, if unemployment falls rapidly while vacancies, wages, credit and capacity utilisation accelerate, the labour market can provide an early warning that demand is approaching or exceeding sustainable supply even before broad inflation becomes entrenched.

 

The Indian Precedent

India’s own monetary-policy history demonstrates why employment and output cannot be completely separated from inflation. During the post-2013 disinflation period, inflation fell substantially while monetary policy and structural factors contributed to the restoration of macroeconomic stability. Yet the RBI has repeatedly recognised that disinflation can entail temporary output and employment costs. Its earlier analytical work explicitly noted that monetary policy affects inflation through aggregate demand and that stabilising output around potential remains a legitimate concern even when price stability is the principal objective. ([Reserve Bank of India][5]) The COVID-19 episode provided an even stronger precedent. In 2020–21, the RBI maintained an accommodative stance to revive growth and mitigate the economic damage of the pandemic while simultaneously seeking to keep inflation within its target range. ([Reserve Bank of India][6]) This illustrates the practical meaning of flexible inflation targeting: monetary policy can tolerate temporary deviations from ideal inflation outcomes when the economy has exceptionally large amounts of unused capacity. The same principle should operate in reverse. When employment and capacity utilisation become exceptionally strong, monetary policy should be prepared to lean against excess demand even if headline inflation has not yet risen dramatically.

 

Data and the Indian Labour-Market Problem

The most important issue is therefore not simply whether India's unemployment rate is high or low but whether it adequately captures the amount of unused labour and productive capacity. PLFS statistics demonstrate why interpretation matters. For April–June 2025, unemployment under the Current Weekly Status measure was 5.4 per cent for people aged 15 and above, with urban unemployment at 6.8 per cent compared with 4.8 per cent in rural areas. ([MOSPI][7]) At the same time, labour-force participation and worker-population ratios can change because people enter or leave the labour force. A falling unemployment rate can therefore occur because employment rises, but it can also occur because discouraged workers stop looking for work. Conversely, rising unemployment can sometimes represent a healthier labour market if more people begin searching for jobs because they believe opportunities are improving. India also has a large informal sector, substantial self-employment and considerable agricultural employment, making conventional unemployment statistics less capable of measuring labour-market slack than they are in economies where salaried employment dominates. Consequently, the RBI should interpret unemployment alongside participation, employment growth, real wages, nominal wages, vacancies, hours worked, youth employment, formal payroll additions, capacity utilisation and productivity.

 

Debate: Is the Phillips Curve Still Relevant?

Critics can reasonably argue that the Phillips curve has become too unstable to serve as a mechanical policy rule. Globalisation, technological change, weaker unionisation, flexible supply chains, anchored inflation expectations and changes in labour-market institutions have weakened the historical relationship between unemployment and inflation. India is also frequently hit by food and fuel shocks, meaning that headline inflation can increase even when domestic demand is weak. The RBI itself acknowledges that the Phillips curve has been questioned internationally and that its relationship can be nonlinear. ([Reserve Bank of India][2]) But rejecting the Phillips curve as a precise forecasting equation would be very different from rejecting its underlying economic logic. The proposition that excess demand eventually encounters capacity constraints, labour shortages and pricing pressure remains economically powerful. The correct conclusion is therefore not that unemployment determines inflation, but that unemployment contains information about the distance between actual economic activity and sustainable capacity. Monetary policy should use that information probabilistically rather than mechanically.

 

Interest Rates and Expectations

The strongest case for incorporating employment into monetary policy is its interaction with interest-rate expectations. Monetary policy works partly by changing borrowing costs today and partly by influencing expectations about future borrowing costs, inflation and economic conditions. If firms believe that demand will remain weak and interest rates will remain restrictive for a prolonged period, they may postpone investment and hiring. Households may also defer interest-sensitive consumption. This can reduce demand further, employment can weaken, wage growth can moderate and inflation expectations can decline. That process can be beneficial when inflation is excessive, but potentially damaging when the economy already contains substantial spare capacity. Conversely, credible communication that rates will remain supportive until employment and demand recover can strengthen investment expectations without requiring the central bank to tolerate permanently high inflation. The objective should therefore be a symmetric reaction function: weak employment and a negative output gap should increase the weight assigned to monetary accommodation when inflation expectations remain anchored, while rapidly tightening labour-market conditions and an emerging positive output gap should increase the weight assigned to monetary restraint.

 

Examples and Policy Implications

Suppose India experiences 7 per cent real GDP growth, falling inflation and a relatively low headline unemployment rate, but participation is weak, real wage growth is stagnant and employment is shifting toward low-productivity activities. A central bank that sees only low inflation and GDP growth might conclude that the economy is healthy and policy can remain neutral. A broader labour-market assessment might instead identify considerable unused economic potential and justify maintaining supportive financial conditions. Conversely, suppose inflation is close to target but vacancies rise sharply, wages accelerate faster than productivity, credit expands rapidly and capacity utilisation approaches historical highs. Waiting for CPI inflation to become persistently excessive could force the central bank to tighten much more aggressively later. Employment indicators could provide an earlier warning. The appropriate lesson is therefore not “lower rates whenever unemployment is high” or “raise rates whenever unemployment is low.” It is to estimate the sustainable employment level and the output gap, examine inflation expectations, and distinguish demand-driven inflation from supply-driven inflation. Employment should become a major state variable in the policy reaction function rather than an afterthought.

 

Conclusion

India does not need to replace inflation targeting with an unemployment target. It needs to make inflation targeting economically richer by recognising that price stability is achieved through the real economy rather than independently of it. The Phillips curve, especially in its expectations-augmented and New Keynesian forms, does not promise a permanent trade-off between inflation and unemployment; instead, it explains why monetary policy can influence employment and output in the short run and why the cost of disinflation depends on the amount of economic slack and the credibility of expectations. India's own policy framework already acknowledges the importance of growth, while RBI research recognises the relevance of output gaps and the nonlinear inflation response to economic activity. ([Reserve Bank of India][2]) The crucial improvement would be to place employment, unemployment, labour participation, wages, vacancies and capacity utilisation much closer to the centre of monetary-policy analysis. A central bank that sees only prices may discover inflation after excess demand has already accumulated; a central bank that watches employment and capacity can see the economic pressure developing underneath the price data. For India, where labour absorption, productivity, income growth and mass consumption are fundamental to development, employment is not merely a social statistic. It is one of the most important indicators of whether monetary policy is allowing the economy to operate close to its sustainable potential. Price stability should remain the anchor, but employment should be one of the principal instruments through which policymakers understand where the economy actually stands.