One of the measures used to determine the health of a country’s economy is the gross domestic product (GDP).

So What is GDP?

GDP is often used to show the overall growth or decline of an economy. Often, it’s referred to as the size of the economy, since it shows the value of all the goods and services produced by the economy.

Most of the time, you’ll see GDP expressed as a measure of growth. So, you might say that GDP grew by -0.1% in the fourth quarter of 2012. Since the number is negative, it is clear that economy contracted in the fourth quarter. In some case, you see positive growth, with GDP increasing by 2%.

Usually GDP measures are contrasted with previous time periods. So the growth or decline is relative to the previous quarter, or it might be relative to the previous year.

How is GDP Figured?

The actual calculations for determining GDP are fairly complex, and difficult for the lay person to understand. However, at its most basic level, GDP is figured by adding up investments, government spending, net exports, and consumption. All of this spending basically indicates the value of the goods and services that drive the economy.

It’s also possible to base GDP calculations on income. In this measure, designated as GDP(I), compensation that companies pay to employees is totaled along with gross profits and taxes (minus subsidies).

Theoretically, GDP and GDP(I) calculations should offer similar results. However, it doesn’t always happen that way.

What is the Impact of GDP?

For the most part, GDP impacts financial markets. Some consumers and others like to know GDP, since it gives an idea of the health of the economy, but the real impact comes on the markets, particularly the stock market.

A growing, healthy economy is thought to provide better profits for companies. That, in turn, means more valuable stock prices, so the stock market rises. When a favorable GDP report is given, the stock market normally reacts by heading higher. On the flip side, a worse than expected report often leads to a drop in stock prices.

GDP is often used to identify whether or not an economy is moving into a recession. If an economy sees contraction in GDP for two consecutive quarters, it is considered to be in recession.

GDP an also indicate when there are inflationary pressures on an economy. If GDP is rising rapidly, indicating that economy is heating up, it can mean that prices are about to rise. Policymakers might then raise interest rates in an effort to slow the economic growth, and keep a  lid on inflation so that prices don’t get out of hand for consumers.

Because GDP is something reported after the passage of a quarter, it can be hard to use it as a measure of what is going on. In some cases, an economy is already moving out of recession by the time the second quarter of contraction is identified. Even with this difficulty, economists, investors, consumers, and policymakers continue to place enormous importance on GDP.