Inflation is defined as an ongoing rise in the general price level over time, and it entails a decline in the value of money; that is, each króna buys a smaller amount of goods and services. The general price level refers to the average price of goods and services in the market, and not the price of a specific product or type of service. An ongoing rise in the price level refers to a series of increases over a relatively long period of time, and not an increase stemming fromfromfrom one-off changes such as changes in the tax system or those due to improved quality of specific goods. Therefore, not all price increases can be classified as inflation. For instance, when petrol prices rise because of a drop in the global oil supply and it becomes more costly to procure oil, such price increases are an example of changes in relative prices, not inflation. In general, monetary policy does not respond to price increases stemming from such factors unless they affect expectations about the future inflation rate.

Many factors affect inflation. If competitive conditions in the market warrant it, firms can raise the price of their goods and services to cover increased production costs such as wage rises. Inflationary pressures also increase if demand growth exceeds supply growth. This is particularly the case for goods and services whose supply is limited to the domestic market. Inflation expectations also play a role: if households and businesses expect inflation to rise, this can stimulate inflation. Employees will demand higher wages if they expect elevated inflation, and firms will increaseraise wages , which will ultimately lead them to raise their prices as well.

The most common measures of changes in the price level are consumer price indices. In Iceland, the index used is the consumer price index (CPI) compiled by Statistics Iceland. The CPI is used both to measure inflation and as a reference for price indexation.

The CPI measures changes in the price of private consumption. Statistics Iceland measures the CPI each month, after having surveyed the price of all goods and services in a defined consumption basket. The consumption basket is based on the results of regularly conducted Statistics Iceland expenditure surveys, which determine which goods and services consumers buy, and in what amounts. The survey findings determine the weight assigned to individual goods and services in the CPI. The expenditure survey has been carried out continuously since 2000, and the results are used in the annual revision of the CPI base.