Inflation is defined as the rise in the average price of goods within a certain period of time. There are several measures of inflation, including the CPI (Consumer Price Index), the PPI (Producer Price Index) as well as the GDP deflator.

Subscribers to the quantity theory of money propose that it is the change in the nominal supply of money which brings about the offsetting changes in wages and prices - in one word, inflation. In this was the case, the real money supply should remain roughly constant. However, statistics from many countries indicate that the nominal supply of money on the one hand, and prices on the other change at a different rate, or even in a different direction. This can be explained with the changes in output and fluctuations in the nominal interest rate. Those latter lead to changes in money velocity, which is the number of transactions served by a unit of money within a unit of time. Inflation may be caused by an expansionary monetary or fiscal policy. Whether a budget deficit will actually lead to inflation depends on the economy's current degree of capacity utilization, the financing of the deficit and, finally, on the central bank policy.

How badly inflation affects an economy depends on whether it has been expected or unexpected. Even when inflation can be foreseen and the agents adapt to the expected rise in prices, it results in increased transaction costs (menu costs and shoe-leather costs).

The key instrument to combat inflation is restrictive monetary policy. Success depends on employees' acceptance of a slower wage growth. The cost of this operation is lower under rational expectations than under adaptive expectations. Tight incomes policy is another instrument helpful in curbing inflation, especially when supported by appropriate institutional changes, such as increased political and economic independence of the central bank from the government.