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Introduction

Interest is a reward for capital.

In the real economic sense, however, interest implies the return to capital as a factor of production. But for all practical purposes, “interest is the price of capital.” Capital as a factor of production, in real terms, refers to the stock of capital goods (machinery, raw-materials, factory plant etc.).

In the money economy, however for all practical purposes capital refers to finance or money capital i.e., the monetary fund’s lent or borrowed for any purpose of expenditure from any source. In strict narrow sense, again, capital may refer to only funds borrowed for real investment in business by the business community from financial institutions.

According to Prof. J. S. Mill – “Interest is the remuneration for mere abstinences.”

  •  As Prof. Keynes has said – “Interest is the reward of parting with liquidity for a specified period.”
  • Demand for money depends on nominal rate of interest rate while investment depends on real interest rate and marginal efficiency of capital. Nominal interest is the sum of real interest rate and the rate of inflation while real interest rate is nominal interest rate corrected for the effects of inflation. In this chapter we will study about different theories of interest rate.
  • There are four theories of interest rate, which are enumerated below:
    1. The Classical Theory of Interest or the Real Theory of Interest 
    1. Neo-classical Theory of Interest or Lonable Fund Theory of Interest
    1. Keynes’ Theory of Liquidity Preference
    2. Neo-Keynesian Theory of Interest or Hicks IS – LM Curve or Modern Theory of Interest

The Classical Theory of Interest or the Real Theory of Interest

This theory was expounded by eminent economists like Prof. Pigou, Prof. Marshall, Walras, Knight etc. According to this theory, Interest is the reward for the productive use of the capital which is equal to the marginal productivity of physical capital. Therefore, those economists who hold classical view have said that “the rate of Interest is determined by the supply and demand of capital. The supply of capital is governed by the time preference and the demand for capital by the expected productivity of capital. Both time preference and productivity of capital depend upon waiting or saving. The theory is, therefore, also known as the supply and demand theory of waiting or saving.”

Demand for Capital

Demand for capital implies the demand for savings. Investors agree to pay interest on these savings because the capital projects which will be undertaken with the use of these funds, will be so productive that the returns on investment realised will be in excess of the cost of borrowing, i.e., Interest. In short, capital is demanded because it is productive, i.e., it has the power to yield an income even after covering its cost, i.e., Interest. The marginal productivity curve of capital thus determines the demand curve for capital. This curve after a point is a downward sloping curve. While deciding about an investment, the entrepreneur, however, compares the marginal productivity of capital with the prevailing market rate of Interest.

Marginal Productivity of Capital = the marginal physical product of capital x the price of the product.

  • When, the rate of Interest falls, the entrepreneur will be induced to invest more till marginal productivity of capital is equal to the rate of Interest. Thus, the investment demand expands when the Interest rate falls and it contracts when the Interest rate rises. As such, investment demand is regarded as the inverse function of the rate of Interest.

Supply of Capital

  • Supply of capital depends basically on the availability of savings in the economy. Savings emerge out of the people’s desire and capacity to save. To some classical economists like Senior, abstinence from consumption is essential for the act of saving while economists like Fisher. Stress that time preference is the basic consideration of the people who save.
  • In both the views the rate of Interest plays an important role in the determination of savings. The chemical economists commonly hold that the rate of saving is the direct function of the rate of Interest. That is, savings expand with the rise in the rate of Interest and when the rate of Interest falls, savings contract. It must be noted that the saving-function or the supply of savings curve is an upward sloping curve.

Equilibrium Rate of Interest

  • The equilibrium rate of Interest is determined at that point at which both demand for and supply of capital are equal. In other words, at the point at which investment equals savings, the equilibrium rate of Interest is determined.
  • This has been shown by the diagram given below:
     
Figure 1: Savings and Investment
  • In the figure 1, given here OR is the equilibrium rate of Interest which is determined at the point at which the supply of savings curve intersects the investment demand curve, so that OQ amount of savings is supplied as well as invested.
  • This implies that the demand for capital OQ is equal to the supply of capital OQ at the equilibrium rate of Interest OR.
  • Indeed, the demand for capital is influenced by the productivity of capital and the supply of capital.
  • In turn savings are conditioned by the thrift habits of the community. Thus, the classical theory of Interest implies that the real factor, thrift and productivity in the economy are the fundamental determinants of the rate of Interest.

It’s Criticisms

The theory of Interest of the classical economists has been severely criticized by Keynes and others. The important criticisms are as under:

  1. Interest is purely a monetary phenomenon:
    • According to Keynes—Interest is purely a money phenomenon, a payment for the use of money and that the rate of Interest is a reward for parting with liquid cash (i.e., dishoarding) rather than a return on saving.
    • Keynes has said that one can get interest by lending money which has not been saved but has been inherited from one’s forefathers. It completely neglects the influence of monetary factors on the determination of the rate of Interest.
    • The classical economists regarded money as a „veil‟ as a medium of exchange over goods and services. They failed to take into account money as a store of value.
  2. The theory of interest is confusing and indeterminate:
    • Keynes has said that the classical theory of Interest is confusing and indeterminate.
    • We cannot know the rate of Interest unless we know the savings and investment schedules which again, cannot be known unless the rate of Interest is known. Thus, it can be said that the theory fails to offer a determinate solution.
  3. This theory is unrealistic and inapplicable in a dynamic economy:
    • Because it assumes that income not spend on consumption should necessarily be diverted to investment, it ignores the possibility of saving being hoarded.
    • It fails to integrate monetary theory into the general body of economic theory.
  4. Classicists have described the rate of interest as an equilibrating factor between savings and investment:
    • But according to Keynes, “the rate of interest is not the price which brings into equilibrium the demand for resources to invest with the readiness to abstain from present consumption.
    • It is the price which equilibrates the desire to hold wealth in the form of cash.”
  5. This theory is narrow in scope:
    • Because it ignores consumption loans and takes into account only the capital used for productive purposes.
  6. Keynes differs with the classical economists even over the very definition and determination of the rate of interest:
    • Keynes has said that Interest is the reward of parting with liquidity for a specified period. He does not agree that Interest is determined by the demand for and supply of capital.
    • With these arguments Keynes has completely dismissed the classical theory of Interest as absolutely wrong and inadequate. He has never been agreeable with the view of classists.

Neo-classical Theory of Interest or Loanable Fund Theory of Interest

  • The Neo-classical or the Loan-able Fund Theory was expounded by the famous Swedish economist Knot Wick-sell. Further, this theory was elaborated by Ohlin, Roberson, Pigou and other new-classical economists.
  • This theory is an attempt to improve upon the classical theory of Interest. According to this theory, the rate of Interest is the price of credit which is determined by the demand and supply for loanable funds. It incorporates monetary factors with the non investments.
  • Loanable fund theory agrees with the view that time preference plays an important role in determining the occurrence of interest.
  • According to neo-classical economists, interest is the amount paid for loanable funds. It focuses on the determination of rate of interest with the help of demand and supply of loanable funds in the credit market.
  • In the words of Prof. Lerner: “It is the price which equates the supply of „Credit‟ or Saving Plus the Net increase in the amount of money in a period, to the demand for „credit‟ or investment Plus net „hoarding‟ in the period.”

Demand for Loan-able Funds

The demand for loanable funds has primarily three sources:

  1. Government,
  2. Businessmen, and
  3. Consumers, who need them for purposes of investment, hoarding and consumption
  • The Government borrows funds for constructing public works or for war preparations or for public consumption (to maintain law and order, administration, justice, education, health, entertainment etc.). To compensate deficit budget during depression or to invest in and for other development purposes. Generally government demand for loanable funds is not affected by the Interest rate.
  • The businessmen borrow for the purchase of capital goods and for starting investment projects. The businessmen or firms require different types of capital goods in order to run or expand their production. If the businessmen do not possess sufficient money to purchase these capital goods, they take loans.
  • Businessmen investment demand for loanable funds depends on the quantity of their production. Generally, the interest and firm’s investment demand for loanable funds has also inverse relationship. It means there will be less demand on higher Interest and more demand on lower Interest.
  •  The consumers take loans for consumption purposes. They prefer present consumption, they wish to purchase more consumption, goods than their present income allows and for that they take loans. They take loans to purchase mainly two types of consumption goods.
  •  First, durable consumption goods and secondly to purchase consumption goods of daily use and they generally open their accounts with the seller and go on purchasing goods on credit basis. Besides these they take loans for investment or speculative purposes also. Behind this they have profit motive.

Supply to Loanable Funds

  • The supply of loanable funds comes from savings, dis-hoardings and bank credit. Private savings, individual and corporate are the main source of savings. Though personal savings depend upon the income level, yet taking the level of income as given, they are regarded as Interest elastic. The higher the rate of Interest, the greater will be the inducement to save and vice-versa.
  •  There is a positive relationship between Interest-rate and the supply of loanable funds. It means there will be more supply of loanable funds at higher interest and less supply on lower interest. Hence the supply curve of loanable funds will be an upward sloping curve from left to right.

Determination of Interest Rate

  • The equilibrium between the demand for and supply of loanable funds (or the intersection between demand and supply curves of loanable funds) indicates the determination of the market rate of interest. It has been shown in the figure 2 given here.
  •  In the figure 2 demand curve for loanable funds (DL) and supply curve of loanable funds (SL) meet at point E. Therefore, E will be the equilibrium point and OR will be the equilibrium rate of interest. At this rate of interest demand for and supply of loanable funds both are equal to OL.

Figure 2: Equilibrium between the demand for and supply of loanable funds
  • Given the supply of loanable funds, if the demand for loanable funds rises, the Interest rate will also rise and if the demand for loanable funds falls, the Interest rate will also fall. Similarly, given the demand for loanable funds, Interest rate will rise with the fall in the supply of loanable funds and will fall with the rise in the supply of loanable funds. The equilibrium rate of interest is thus determined where SL = DL.

It’s Criticisms:

  1. It has been called as indeterminate theory:
    • Prof. Hansen asserts that the loanable funds theory like the classical and the Keynesian theories of Interest are indeterminate. Because according to this theory Interest rate determination depends on savings.
    • But saving depends on income, income depends on investment and investment itself depends on Interest rate.
  2. In this theory the equilibrium between demand for and supply of loanable funds cannot be brought by the changes in interest rate:
    • Investment in the demand for loanable funds and savings in the supply of loanable funds are important elements. Both saving and investment are not so much influenced by Interest as they are influenced by the changes in income levels.
    • Besides this, it is not essential that banks would necessarily change their Interest rate with the changes in demand for and supply of loan-able funds. Banks determine their Interest rate keeping in view so many factors and they would not like to make frequent changes in it.
    • In this situation it would be difficult to bring equilibrium in demand for and supply of loan-able funds through the changes in the Interest rate.
  3. This theory exaggerates the effect of the rate of interest on savings:
    • Regarding this theory critics argue that people usually save not for the sake of interest but out of precautionary motives and in that case, saving is Interest inelastic.
  4. Availability of Cash balance which is not elastic:
    • The loanable funds theory states that the supply of loanable hands can be increased by releasing cash balances of savings and decreased by absorbing cash balances into savings.
    • This implies that the cash balances are fairly elastic. But this does not seem to be correct view because the total cash balances available with the community are fixed and equal the total supply of money at any time.
  5. Government influence on the demand:
    • Government has an important influence on the demand for and supply of loanable funds. And it is not essential that government may always take the decisions in view of Interest rate.
    •  Rather government generally takes the decisions keeping in view the public Interest and not the Interest rate.

Keynes’ Theory of Liquidity Preference

  • According to Keynes, Interest is purely a monetary phenomenon. It is the reward of not hoarding but the reward for parting with liquidity for the specified period. It is not the „Price‟ which brings into equilibrium the demand for resources to invest with the readiness to abstain from consumption.
  •  It is the „Price‟ which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash. Here Liquidity Preference Theory is determined by the supply of and demand for money. Supply of money comes from banks and the government.
  • On the other hand, demand for money is the preference for liquidity. According to Keynes people like to hoard money because it possesses liquidity. Hence, when somebody lends money he has to sacrifice this liquidity. A reward which is offered to make him prepared for parting with liquidity is called Interest. Therefore, in the eyes of Keynes—”Interest is the reward for parting with liquidity for a specific period.”

Meaning of Liquidity Preference

  • Before studying the determination of rate of interest we should know the meaning and motives of liquidity preference.
  • Wealth is generally preferred to be kept in cash in any society. There are various forms in which income and wealth are kept in the most liquid form of wealth and income in cash or money. If wealth or income is kept in cash it can be used for any purpose and there is no difficulty and it will be a facility to use the income at desire. Income or wealth can be kept in the form of land, building, shares, debentures, government securities, etc., but it cannot be used in the form of money or cash. Thus liquidity means cash.
  • The liquidity can be studied with reference to the rate of interest. If in any society people prefer to keep their income in the form of liquidity then we have to pay higher rate of interest. People will be prepared to part with liquidity when they are paid higher rate of interest. When the rate of interest is low they will prefer to keep if in liquid form.
  • Thus, interest is a reward for parting with liquidity. Hence higher the liquidity preference higher will be the rate of interest and lower the liquidity preference lower will be the rate of interest.

Liquidity Preference or Demand for Money

  • Liquidity preference means demand for cash or money. People prefer to keep their resources “Liquid”. It is because of this reason that among various forms of assets money is the most liquid form.
  • Money can easily and quickly be changed in any form as and when we like. Suppose, you have a ten rupee note now you can change it into either wheat, rice, sugar, milk, book or in any other form you like.
  •  It is because of this feature of liquidity of money, people generally prefer to have cash money.

The desire for liquidity arises because of three motives

  1. Transaction motive:
    • The transactions motive relates to “the need of cash for the current transactions of personal and business exchanges”.
    •  It is further divided into the income and business motives. The income motive is meant “to bridge the interval between the receipt of income and its disbursement”, and similarly, the business motive as “the interval between the time of incurring business costs and that of the receipt of the sale proceeds.”
    •  If the time between the incurring of expenditure and receipt of income is small, less cash will be held by the people for current transactions and vice-versa.
  2. The precautionary motive:
    • The precautionary motive relates to “the desire to provide for contingencies requiring sudden expenditures and for unforeseen opportunities of advantageous purchases.”
    •  Both individual and businessmen keep cash in reserve to meet unexpected needs. Individual hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies.
    • Similarly, businessmen keep cash in reserve to tide over unfavorable conditions or to gain from unexpected deals.
  3. The speculative motive:
    • Money held under the speculative motive is for “securing profit from knowing better than market what the future will bring forth.”
    • Individuals and businessmen have funds, after keeping enough for transactions and precautionary purposes, like to gain by investing in bonds. Money held for speculative purposes is a liquid store of value which can be invested at an opportune moment in Interest bearing bonds on securities.
    • There is an inverse relationship between interest rate and the demand for money i.e., more demands for money at lower Interest rate and less demand at higher interest rate. Hence, the liquidity preferences curve becomes a downward sloping curve.

Supply of Money

  • The supply of money refers to the total quantity of money in the country for all purposes at any time. Though the supply of money is a function of the rate of Interest to a degree, yet it is considered to be fixed by the monetary authorities, that is, the supply curve of money is taken as perfectly inelastic.
  • The supply of money in an economy is determined by the policies of the government and the Central Bank of the country. It consists of coins, currency notes and bank deposits. The supply of money is not affected by the Interest rate, hence, the supply of money remains constant in the short period.

Determination of Interest Rate

  • According to the Liquidity-Preference Theory the equilibrium rate of interest is determined by the interaction between the liquidity preference function (the demand for money) and the supply of money, as presented in figure 3 below:

Figure 3:Liquidity preference function and the supply of money
  • OR is the equilibrium rate of interest. The theory further states that any change in the liquidity preferences function (LP) or change in money supply or changes in both respectively cause changes in the rate of interest.
  • Thus as shown in figure 4 below, it given the money supply the liquidity preference curve (LP) shifts from LP1 to LP2 implying thereby an increase in demand for money, the equilibrium rate of interest also rises from to R%.
Figure 4:Liquidity preference function and the supply of money

Similarly, assuming a given liquidity preference function (LP) as in figure (b) When the money supply increases from M1 to the rate of interest falls from R1 to R2.

It’s Criticisms

  1. The Theory Ignores Real Factors: It ignores real factors while determining the rate of interest. The theory is purely a monetary theory. Sacrifice, waiting and productivity are the real factors which are also important for the determination of the rate of interest.
  2. No Liquidity without Saving: The theory emphasizes on the liquidity and rate of interest is considered as a reward for parting with liquidity. Liquidity cannot be possible without saving.
  3. One Sided Theory: The theory assumes that the supply of money or liquidity remains constant while the demand for liquidity changes and the rate of interest is determined where LP curve cuts the SM curve. It has emphasized on the demand for liquidity while the supply of liquidity is kept constant which is one sided determination of the rate of interest.
  4. The Theory is Related with Short Period: It fails to determine the rate of interest during the long period. During long period trade cycles lead to fluctuations and in such a situation theory fails to determine the rate of interest.
  5. The Theory Fails to Explain the Causes of Different Rates of Interest: It does not explain the differentials in interest rate keeping the uniformity in the liquidity preference of the people.
  6. Contrary to Facts: The liquidity preference theory of interest is contrary to the general experience and facts. The rate of interest should be the highest during the lowest level of depression because people have demand for liquidity but it is not so which has not been explained by the theory. Rates of interest are at the highest when the prosperity is at its highest level.
  7. Indeterminate: The liquidity preference theory of interest is indeterminate. As pointed out by Professor Keynes that the rate of interest is determined by the liquidity preference and the quantity of money. Until and unless we know the level of income the demand and supply of money cannot be known and the rate of interest remains indeterminate. Prof. Keynes has failed in explaining this point.
  8.  Money as Store of Wealth is not Correct: The theory assumes that liquidity or money plays a role of store of wealth or speculative purpose but in practice we see that money is as productive as other assets are.
  9. Limited Scope: The liquidity preference theory is a monetary theory for the determination of rate of interest. Monetary factors have been taken into consideration. It means the theory is applicable in monetary economies only and it cannot be applied to non-monetary economies.

Neo-Keynesian Theory of Interest or Hicks IS – LM Curve or Modern Theory of Interest

  • Classical economists determined the rate of interest with the help of the saving and investment in the goods market.                                                                                                                                                 
  • Neo-classical economists determined the rate of interest (r) with the help of demand for and supply of loanable funds by incorporating both real sectors and monetary sectors. Keynes completely denied the real factors represented by real savings and investment (so much emphasized by both classical and neo-classical economists) in determination of rate of interest (r).
  • Keynes tried to determine rate of interest with the help of the demand for and supply of money in the money market as L1 (Y) + L2 (r) = MS , which contained besides r, another unknown income (Y) in his demand for money, Md functions. This is invalid because unless we know the value of Y, the equilibrium equation {(i.e., L1 (Y) + L2 (r) = MS } cannot be used to determine r.
  • Keynes’ solution procedure involved him into the circularity of reasoning that is Keynes says that rate of interest, r determines investment and investment determines income through multiplier process. Thus, r influences income, Y and is influenced by Y. This represents a case of join determination of rate of interest.
  • Hicks (1937) removed this analytical flaw in Keynes’ model through IS-LM curve. Thus, Hicks IS-LM model is also known as neo-Keynesian model.
  • Now it is widely believed that it is both real or goods market forces and money market forces determine rate of interest and real income. The commonly accepted model for joint determination of rate of interest and the real income is Hick’s IS-LM model.
  • The key feature of Hicks’ (or Keynesian) model is the joint determination of rate of interest and the real income. It also shows the interaction of the commodity market and the money market.
  • Hicks and Learner have synthesized the theory of both classical’ saving-investment theory, and Keynes’ liquidity preference theory into a new theory, which is known as Hicks’ IS-LM model. This theory is also known as the determinate theory of interest rate (since classical theory of interest; loanable funds theory of interest, and Keynes liquidity preference theory were all indeterminate theory of interest because these theories failed to relate rate of interest with the income).
  • This theory has taken out four important elements viz; (i) saving, and (ii) investment from classical theory of interest, and (iii) liquidity preference or demand for money/ cash, and (iv) supply of money from keynes’ liquidity preference theory to determine rate of interest and real income jointly in both commodity market and money market with the help of IS and LM curve.
  • IS curve has been derived from the combination of saving and investment in commodity market. Thus, the IS curve shows us, for any given interest rate, the level of income that brings the goods market into equilibrium. So, the IS curve represents equilibrium in the market for goods and services.
  • The IS curves shows the combination of the interest rate and the level of income that are consistent with equilibrium in the market for goods and services.
  •  LM curve has been derived from the combination of liquidity preference and supply of money in the money market. Thus, the LM curve tells us the interest rate that equilibrates the money market at any level of income. So, LM curve represents the equilibrium in the money market for real money balances. The LM curve shows the combinations of the interest rate and the level of income that is consistent with equilibrium in the market for real money balances.
  • Note that IS curve does not determine income, Y or the interest rate, r. instead, the IS curve is a relationship between Y and r arising in the market for goods and services, or equivalently, the market for loanable funds. To determine the equilibrium of the economy, we need another relationship between these two variables and that is LM curve. The IS and LM curves together determine the interest rate and the national income in the short run when the price level is fixed.
  • Now, let us see how these two curves viz; IS and LM is constructed.

Derivation of IS curve

  • The IS curve can be depicted by the diagram where different levels of income and rates of interest are studied and total real savings are equal to total real investment. The derivation of IS curve can be studied from figure 5.
Figure 5: Derivation of IS Curve
  • The part of the figure 5 shows the relationship between the rate of interest and the saving and investment. SS, S1S1 and S2Sare different levels of savings at different levels of income and the points of equilibrium between saving and investment are shown by E, E1 and E2 whereas the rate of interest are OR, OR1 and OR2. It is the investment curve where the relation between rate of interest and investment is inverse. Higher the rate of interest lower will be the investment and lower the rate of interest higher will be the investment.
  • When the rates of interest at different levels of income having equilibrium between saving and investment are expressed by a curve knows as IS curve as shown in the part (B) of the figure 5. IS curve show the relationship between different levels of income and rates of interest in which the related saving and investment are in equilibrium.
  • The slope of IS curve is negative showing the inverse relationship between the level of income and the rate of interest. At the higher level of income saving will be high and rate of interest will be low while at the lower level of income the saving will be low and the rate of interest will be high.

Derivation of LM Curve

LM curve shows the various combinations of different levels of income (y) and rates of interest (r) wherein there is equilibrium between the demands for money and supply of money. It can be seen from figure 6.

Figure 6:Derivation of LM Curve
  • The part (A) of the figure 6 shows that there is positive relationship with the liquidity preference and the rate of interest keeping the supply of money (SM) constant. LP increases with the increase in the level of income and thereby the rate of interest increases.
  • In part (B) of the figure 6, the LM curve has been shown wherein there is positive relationship between the rate of interest and the levels of income. Its each point shows equilibrium between the demand for money and supply of money. When the supply of money is given then the increased income will increase the liquidity preference and the rate of interest will increase.

Determination of Rate of Interest

The rate of interest is determined at the point where the IS curve and LM curve intersects each other.

Figure 7: Determination of Rate of Interest
  • Rate of interest is shown on OY-axis and the level of income on OX-axis. The rate of interest is determined at point E where the IS curve cuts the LM curve. The rate of interest is OR and the level of income is OY1.
  •  It shows the equilibrium between saving and investment (SI) on the one hand and equilibrium between liquidity and supply of money (LM) on the other.

Criticisms of the Modern Theory of Interest:

  1. Static Theory: It is a static theory that explains the short-run behavior of the economy. Thus it fails to explain how the economy behaves in the long run.
  2.  Interest Rate not Flexible: The theory is based on the assumption that the interest rate is flexible and varies with changes in LM or/and IS curves. But it may not always happen if the interest rate happens to be rigid because the adjustment mechanism will not take place.
  3.  Investment not Interest Elastic: The theory assumes that investment is interest elastic. But if investment is interest inelastic, as is generally the case in practice, then the Hicks-Hansen theory does not hold good.
  4. Highly Artificial: According to Don Patinkin, the Hicks-Hansen theory is highly artificial and oversimplified because it divides the economy into real and monetary sectors. In reality, the real and monetary sectors of the economy are so interrelated and interdependent that they act and react on each other.
  5.  Closed Model: According to Prof. Rowan, the Hicks-Hansen theory is a closed model which does not take into consideration the effect of international trade. This restricts its usefulness for the study of policy.
  6. Price Level Exogenous Variable: The price level is treated as an exogenous variable in this model. This is unrealistic because price changes play an important role in the determination of income and interest rates in an economy. Despite these weaknesses, this theory does not undermine the utility of the IS-LM technique in explaining the determination of interest rate in an economy.

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