Inflation is defined as a permanent rise in the general price level over time, and it entails a decline in the value and purchasing power 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, not to the price of an individual product or type of service. A permanent rise in the price level refers to a series of price increases over a relatively long period, and not to a price increase stemming from a single cause, such as a change in taxes or an improvement in the quality of a given product. In general, monetary policy does not respond to such one-off changes in the price of a specific product or service unless they affect expectations about future inflation.

Many factors can affect inflation. Firms can raise the price of their goods and services to cover increased production costs such as wage rises. Furthermore, inflationary pressures can increase if growth in demand – i.e., households’ and businesses’ ability and willingness to buy – outpaces growth in supply. This is particularly the case for goods and services produced in Iceland.

Expectations about inflation are important as well. If households and businesses expect inflation to rise, this can stimulate inflation. Wage-earners will demand higher pay if inflation is expected to rise. If wages rise too much, companies will raise their prices so that they can cover wage payments. Companies are also more likely to raise their prices if they expect other companies to do the same. In this way, expectations of higher inflation in the future can push current inflation higher.

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 to measure inflation and is also the most commonly used reference for price indexation.

The CPI measures changes in the price level of private consumption. Statistics Iceland computes the CPI on a monthly basis, based on measurements of the price of all goods and services included in a predefined household consumption basket. The consumption basket is based on the results of regularly conducted Statistics Iceland spending surveys, which determine which goods and services consumers buy, and in what amounts. The results of the spending surveys therefore determine which specific goods or services are included in the CPI.