The real GDP of an economy is its total output, or nominal GDP, adjusted for inflation. It is comprised of consumer expenditure, governmental expenditure, investment expenditure and net exports. The real GDP of an economy may fall as a result of three reasons, all of which are due to changes in domestic prices.
On a macro-level of analysis, aggregate demand is used. Aggregate demand is essentially the sum of demand from individuals and firms on the micro-level. When discussing demand in terms of the macro level, demand is equivalent to real GDP, or the level of output in an economy adjusted for inflation. Aggregate demand is combined with aggregate supply in an aggregate demand analysis, that is, the equilibrium levels of price and quantity in a given economy. When graphed, with prices on the y-axis and GDP on the x-axis, the aggregate demand curve slopes downward.
A Rise of Interest Rates
The first reason for a decrease in real GDP is interest rates. When prices increase but the supply of money remains fixed, increased demand for money causes interest rates to rise. When these rise, spending decreases, as the cost of money is greater. Therefore, consumer expenditure, one of the largest components of GDP, falls. Governmental expenditure falls in a similar manner. Investment also falls, as the rate of borrowing of finance falls as a result of more expensive loans.
A Rise of Imports
The second reason is that of net exports. When the price of domestic goods rises, the demand for imports increases. One of the components of GDP is net exports. Net exports are equal to the total amount of exports in a given period, minus the total amount of imports in the same period. Thus, when imports rise, net exports fall. A fall in net exports in turn decreases nominal GDP and thus real GDP.
A Fall in Purchasing Power
The third reason is called the wealth effect. When prices rise and the supply of money is constant, wealth, when measured in purchasing power, declines. If oranges cost $1 today and $2 tomorrow, and if your income remains the same, your purchasing power, and thus real wealth, falls. Real GDP captures spending power, whereas nominal GDP, which does not account for the change of prices as a result of inflation, does not.