First, Apple's explanation: Mac OS X: Reading system memory usage in Activity Monitor
In short, both inactive and free memory represent the amount of physical memory (a.k.a., RAM) available to applications. Inactive differs from free in that Mac OS X is keeping it as a cache memory (i.e., instead of reloading data from the disk, it will be immediately available). In other words, Mac OS X prefers to keep unused memory as inactive than free. OS is supposed to reclaim inactive as free when free is all used up.
In practice, this reclaim process does not happen consistently/quickly enough. And the result is page out -- when OS cannot allocate free memory or reallocate inactive memory for application, it borrows memory from disk in the form of virtual memory (found on /var/vm directory). Disk is obviously many times slower than memory. So when data is accessed from memory, particularly when OS needs to expand virtual memory (by default, it will pre-allocate about 70 MB of disk space for virtual memory), you will experience infamous Mac OS X phenomenon called "beach balling."
Even with plenty of RAM, say 2 GB or more, it's all too common to experience some amounts of page out. The next version of Mac OS X is rumored to feature more advanced garbage collection framework, so perhaps beach balling will become less prevalent phenomenon. In the mean time, if you have lots of swap files under /var/vm (and very high page out count), you will benefit from more RAM.
In short, both inactive and free memory represent the amount of physical memory (a.k.a., RAM) available to applications. Inactive differs from free in that Mac OS X is keeping it as a cache memory (i.e., instead of reloading data from the disk, it will be immediately available). In other words, Mac OS X prefers to keep unused memory as inactive than free. OS is supposed to reclaim inactive as free when free is all used up.
In practice, this reclaim process does not happen consistently/quickly enough. And the result is page out -- when OS cannot allocate free memory or reallocate inactive memory for application, it borrows memory from disk in the form of virtual memory (found on /var/vm directory). Disk is obviously many times slower than memory. So when data is accessed from memory, particularly when OS needs to expand virtual memory (by default, it will pre-allocate about 70 MB of disk space for virtual memory), you will experience infamous Mac OS X phenomenon called "beach balling."
Even with plenty of RAM, say 2 GB or more, it's all too common to experience some amounts of page out. The next version of Mac OS X is rumored to feature more advanced garbage collection framework, so perhaps beach balling will become less prevalent phenomenon. In the mean time, if you have lots of swap files under /var/vm (and very high page out count), you will benefit from more RAM.