In other words, money is demanded because it is a good medium of exchange. Therefore, we can say that L, becomes highly interest-elastic as the interest rate rises beyond transactions cost. The stock exchange market strike a balance between the opposite group of expectations. This fact can be expressed in the form of an equation as: L p = f(Y) According to Keynes, demand for money for precautionary motives depends on income. Therefore, as long as the rate of interest paid on assets or securities is greater than zero, no individual or business firm will hold cash balances to meet transactions requirements (provided the cost of liquidating the assets into cash called transfer cost does not exceed the interest payment). This is because investors prefer cash and, barring that, prefer investments to be as close to cash as possible. In fact, it may be understood that the need to bridge the gap between income and expenditures and to finance day-to-day transaction, is not the only reason that gives rise to transactions motive for holding cash balances. An obvious answer is provided by the subjective considerations of individuals regarding liquidity motives for the satisfaction of which they desire to hold money balances. Determine the market demand and market supply functions for commodity x. In Fig. Those motives are the transaction motive, the precautionary motive, and the speculative motive (Pal, n.d.). Share Your PPT File, Differences between Classical and Keynesian Theories of Interest. Liquidity preference theory is a classical model that proposes that an investor should mandate a higher interest rate or premium on securities with long-term maturities that are prone to high risk. 20.3 Lt is the demand for money for transaction purposes and Lt shows the demand for money for precaution purposes. This occurs at the rate of 2 per cent, a rate so low that wealth-holders believe that it can go no lower. Answers (1), State the factors that a business firm should consider while developing an advertising policy, Date posted: February 7, 2019. 400 crore, 100 crore will be required for transaction purposes (because k = 1/4). 1. E. Transactions motive. According to John Keynes, there are three motives of liquidity theory: 1. The transactions, finance and precautionary motives are assumed to be largely interest-inelastic; only the speculative motive is sensitive to the rate of interest (Keynes, 1936, p. 199). At this rate no one likes money to bonds. Give examples of each. Not only individuals and households need money to meet daily transactions, but business firms also need it to meet daily requirements like payment of wages, purchase of raw materials and to pay for transport etc. 1. 100). D. Speculative motive. Major differences between quantity and the Keynesian Liquidity preference theories of money demand. The individual investors are not sure of the terms and conditions on which debts owned can be converted into cash. In macroeconomic theory, liquidity preference is the demand for money, considered as liquidity. While a liquidity trap is a function of economic conditions, it is also psychological since consumers are making a choice to hoard cash instead of choosing higher-paying investments because of … Liquidity refers to the convenience of holding cash. 20.2. It is this “uncertainty as to the future course of the rate of interest which is the sole intelligible explanation of this type of liquidity preference”. 20.4 shows that the higher the rate of interest, the smaller the amount of assets that wealth-holder choose to hold in money form. Thus, the precautionary demand for money according to Keynes is also income-elastic, it is expressed as Mp = ƒ(Y), where Mp is the precautionary demand for money and ƒ (Y) denotes it to be the function of income. Liquidity preference means the desire of the community to hold cash. 500 crore and k is 1/4 then Lt will be Rs. C. Price level motive. According to Keynes, the demand for money is split up into three types – Transactionary, Precautionary and Speculative. The influence of interest rate is much less or insignificant. Income motive. Explain the extent to which advertising influences demand. They are 1. 500 crore, the Lt curve shifts to Y2, (given K = 1/4), but again slopes backward beyond the rate of interest of 4%. The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate by the supply and demand for money. 400 crore. In a perfectly competitive market the average revenue and average cost functions are: Primary and High School Exams in Kenya With Marking Schemes. Share Your Word File The reason why individuals or business firms hold assets againstcash when cash is more convenient to hold, is that there is a 100 cost of holding idle cash balances. The three divisions of liquidity-preference which we have distinguished above may be defined as depending on (i) the transactions-motive, i.e. In a perfectly competitive market the average revenue and average cost functions are:Based on the given functions, determine: The level of output at which the firm break-evens, In a perfectly competitive market the average revenue and average cost functions are:Based on the given functions, determine: Fixed and Variable cost functions. Keynes emphasized speculative demand for money as he felt that people kept cash to take advantage of the rise and fall of prices of bonds and securities. 100 crore denote L, out of Rs. According to this theory, the rate of interest is the payment for parting with liquidity. 100 crore holds true as long as the rate of interest is not above 4%, for example, As the rate rises above 4%, the figure shows that Lt for money becomes interest-elastic, showing that given the cost of switching into and out of securities, an interest rate above 4% is sufficiently high to attract some amount of transactions balances into securities. 4 to liquidate a bond whose market value is Rs. No two persons have identical time patterns of payments and few find their total payments for any month evenly distributed over the period. WE must now develop in more detail the analysis of the motives to liquidity-preference which were introduced in a preliminary way in Chapter 13. If the total quantity of money remains unchanged, speculative transactions affect output and employment by changing the rates of interest. Answers (1), One of the determinants of demand for a commodity is advertisingExplain the extent to which advertising influences demand, Compute the market equilibrium price (Px) and quantity (Qx). But there is an inverse relationship between the rate of interest and the holding of precautionary balances, that is. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. Individuals do not receive money income as frequently as they make payments; lot of time, therefore, elapses between the receipt of income and its expenditure. At the other end of the curve speculative demand becomes perfectly elastic. The influence of interest rate and transactions cost on transactions demand for money can be easily explained. It shows that changes in the transaction balances (Lt) are the result of changes in Y rather than changes in k. It may also be noted that the transactions needs of individuals and business firms could be financed by liquidating at the appropriate time—real assets or financial assets. 20.2 if Y is Rs. It is here that Keynes’ theory differs in a fundamental sense from the classical theory of interest. Transaction motive, Precautionary motive, Speculative motive, liquidity trap. Keynes states in his Liquidity Preference theory that there are three motives that drive people’s desire for liquidity. It depends upon the level of income and is interest inelastic. The cash balances held on account of precautionary motive will differ with individuals and business firms, according to their degree of confidence, wave of optimism or pessimism, access to credit and finance and the facilities for the quick conversion of illiquid assets like bond and securities into cash. According to Keynes people demand liquidity or prefer liquidity because they have three different motives for holding cash rather than bonds etc. ... transactions, precautionary and speculative motives, arguing that the demand for money is positively related to income and negatively related to interest rate, which should not fall below the investors’ normal rate of interest. The Liquidity Preference Theory says that the demand for money is not to borrow money but the desire to remain liquid. Thus, we find that the speculative demand for money—an integral part of the demand for money in Keynesian theory—represents a distinct break with Classical theory. Individuals, households and business firms find it a good practice to hold money than what is needed for transactions purposes. The cash money is called liquidity and the liking of the people for cash money is called liquidity preference. Suppose one expects a fall in the prices of bonds, one will like to hold more cash with a view to spending it in future, when prices actually fall. On The Basis Of These Motives, What Variables Did He Think Determined The Demand For Money? The basic motives for holding money rather than investments are the liquidity provided by money. According to Keynes, four motives drive the demand for liquidity: the transactions, finance, precautionary and speculative motives (Keynes, 1936, 1937a). Although the major influence on precautionary balances, according to Keynes’ position, is that of income yet the influence of the rate of interest cannot be underestimated, because at low interest it is more attractive to hold cash than assets. Similarly, people purchase bonds in anticipation of a rise in their prices. If, however, the rate of interest is higher than 4%, interest income earned on financial assets exceeds the transactions costs and there is a clear incentive to move out of cash into interest- bearing assets and the higher the rate of interest rises, the greater the inducement to move into interest-bearing assets. What three motives for holding money did Keynes consider in his liquidity preference theory of the demand for real money balances? On the other hand, demand for money or liquidity preference for speculative motive is interest elastic, i.e., the function of interest. According to Keynes, there are three motives behind the desire of the public to hold liquid cash: (1) the transaction motive, (2) the precautionary motive, and (3) the speculative motive. This is called speculative demand for money. In other words, money is demanded because it is a good medium of exchange. It may be so at a relatively low rate of interest, but becomes increasingly responsive at relatively high rates of interest. This figure of Rs. Make a distinction between fixed and variable costs of production. Date posted: March 18, 2019. Liquidity preference can be thought of as stemming from the following sources: (i) The precautionary motive This relates to the factor that causes people or firms to hold a stock of money in order to finance unforeseen 20.1. Precautionary balances and their size is determined by the size of the assets owned by firms and individuals. Precaution Motive 3. Liquidity Preference Hypothesis A theory stating that, all other things being equal, investors prefer liquid investments to illiquid ones. © 2008-2020 by KenyaPlex.com. Such a portfolio decision of Individuals and firms concerning the holding of idle balances or other assets depends on the accumulated wealth (w), rate of interest (r), uncertain future (Ur) and the attitude of people towards risk and income, that is, the speculative or asset demand for money can be shown symbolically as : La – ƒ(r, Ur, w). Distinguish between a trade-off and an opportunity cost in macroeconomic theory. If the units— individual or firms expect their future income to go up and there is easy availability of credit, financial institutions providing facilities of liquidity covertion of securities etc.—then there may not be much need to hold precautionary balances. (Check all that apply.) This relationship is shown in the Fig. There is a gap between the receipt of wages, salaries or incomes and their expenditure. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. According to​ Keynes's liquidity preference​ theory, the three motives for holding money are when the interest rate decreases. All Rights Reserved | Home | About Us | Contact Us | Copyright | Terms Of Use | Privacy Policy | Advertise, Explain the reasons for liquidity preference for money. According to W.W. Haines the precautionary demand for money is influenced by factors like the size of assets, availability of insurance, expectations of future income, availability of credit and the efficiency and safety of financial institutions in making interest-earning assets available. According to Keynes, there are three motives behind the desire of the people to hold liquid cash: (1) The transaction motive, (2) The precautionary motive, and If everyone received income in cash and simultaneously paid it in cash, there would be no need for holding cash balances, but that is not the case in actual practice. The subject is substantially the same as that which has been sometimes discussed under the heading of the Demand for Money. Thus, as a general rule, we may say that the transaction demand for money is income-elastic and may be expressed as Md = ƒ(Y), where Md is the transaction demand for money and ƒ (Y) denotes it to be the function of income. Most economists generally agree that in actual practice, there is some rate of interest at which the Lt for money for the economy as a whole begins to slope backward, as shown in Fig. As originally employed by John Maynard Keynes, liquidity preference referred to the relationship between the quantity of money the public wishes to hold and the interest rate.. The demand for money for transaction purposes depends upon income and the general level of business activity and the manner of the receipt of income. If, however, the income is Rs. In Fig. What does​ Keynes's liquidity preference theory predict about the relationship between interest rates and the velocity of​ money? transactions, precautionary, and speculative. Liquidity preference or demand for money to hold depends upon transactions motive and specula­tive motive. According to Keynes, there are three motives behind the desire of the public to hold liquid cash: (1) the transaction motive, (2) the precautionary motive, and (3) the speculative motive. As such, it may be concluded that both the transactions demand and precautionary demand for money balances is a function of the level of income (Y) and to some extent the rate of interest (r). Like individuals, business firms also hold cash to safeguard against future uncertainties. For an income level of Rs. Before publishing your Articles on this site, please read the following pages: 1. Using example, differentiate between a firm and an industry, In the context of international trade explain briefly the concept of comparative advantage with specialization, One of the determinants of demand for a commodity is advertising We must now develop in more detail the analysis of the motives to liquidity-preference which were introduced in a preliminary way in Chapter 13.The subject is substantially the same as that which has been sometimes discussed under the heading of the Demand for Money. Speculative motive. Next: What are the differences and similarities between mitosis and meiosis?Previous: Using example, differentiate between a firm and an industry Speculative motive is different from other motives as the sole object of holding money under it is to earn profits by “knowing better than the market what the future will bring.” These speculative holdings are specially sensitive to changes in the rate of interest. However, it may not always be true to say that transactions demand for money is not very responsive to changes in the rate of interest. In other words, it is the reward for not hoarding. the need of cash for the current transaction of personal and business exchanges; (ii) the precautionary-motive, i.e. Question: What Three Motives For Holding Money Did Keynes Consider In His Liquidity Preference Theory Of The Demand For Real Money Balances? John Maynard Keynescreated the Liquidity Preference Theory in to explain the role of the interest rate by the supply and demand for money. In other words, the interest rate is the ‘price’ for money. It is this demand for money which plays a vital role in the functioning of the economic system, for it is through such a demand for money that prices of fixed income-yielding assets (bonds and securities)- are affected and the rate of interest changes. I. Cash is a liquid asset. Therefore, Lt at Yt = Lt at Y1 + Lp at Y1 = B1Y1 + A1B1 = A1Y1. Here we detail about the three motives for liquidity of money by Keynes. Share Your PDF File The Fig. 400 crore. The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds (here, the term "bonds" can be understood to also represent stocks and other less liquid as… Overview of Theory Of Liquidity Preference This means that our equation for transactions demand should become: Lt = f (Y, r) and there is no longer a simple linear relationship between Lt and Y. Here we Understand the Motives of Liquidity Preference Theory in detailed. In fact, there is a direct relation between the size of the assets and the holding of cash for precautionary purposes. The Psychological and Business Incentives To Liquidity I. The theory of liquidity preference posits that the interest rate is one determ inant of ... the speculative motive. The size of k, however, depends on institutional and structural conditions within an economy. This part of the curve is called “liquidity trap”. The speculative demand for money arises on account of the uncertainty regarding the future rate of interest. When, however, the interest payment on these assets is not large enough to cover the transfer or transactions cost (and to compensate the asset holder for any inconvenience caused during the transfer process), no individual or business firm will hold financial assets to meet the transactions requirements. 125 crore. According to Keynes, people have liquidity preference for three motives. This type of demand for money is also determined by income and the general level of business activity. Here we detail about the three motives for liquidity of money by Keynes. Date posted: March 20, 2019. Chapter 15. Lp = ƒ(Y. r). The General Theory by John Maynard Keynes (1936) [Chapter 15 THE PSYCHOLOGICAL AND BUSINESS INCENTIVES TO LIQUIDITY . Keynes termed the demand for money as liquidity preference. It may be called an 80 opportunity cost. The greater the level of income, the greater the amount of money held for transactions motive and therefore the higher the level of liquidity preference curve. At high rates of interest, the curve shows that they will hold no money in speculative balances. The transactions motive for the demand for M1 (directly spendable money balances) results from the need for liquidity for day-to-day transactions in the near future. Like the transaction demand for money, the precautionary demand for money balances also slopes upwards from left to right as shown fig 20.3. Transaction motive; 2. Again, over time the amount of money held will tend to increase to the extent the volume of transactions increase. View More CPA Economics Questions and Answers | Return to Questions Index. The asset demand for money is related to the decision-making by persons and firms regarding the forms of assets in r which their savings are accumulated. 20.1 if k is 1/4, Rs. Liquidity preference for first two motives generally remains fixed. Explain the reasons for liquidity preference for money. It is rather difficult to generalize on the interest elasticity of the transaction demand for money for the economy as a whole. The transaction motive involves our daily purchasing habits. Now, when the rate of interest is also 4% or less, the cost of liquidating assets equals or exceeds the interest income on asset and it is, therefore, more safe to hold money to meet Lt. We may say that Lt is completely interest inelastic at interest rate which are equal to or below the transactions cost, i.e., any increase in the interest rate will not induce a movement from cash into interest-bearing assets. TOS4. According to Keynes, interest is the reward for parting with liquidity for a specified period of time. How much cash a person will hold on account of such unforeseen events will depend upon his psychology and his views about the future and the extent to which he wants protection or insurance against such events. Liquidity preference means the desire of the public to hold cash. The theory asserts that people prefer cash over other assets for three specific reasons. Keynes denotes M 1, the combined demand for these two motives. This may be expressed in the form of an equation: Lt = k (Y), in which Lt is the money balances held for transaction purposes which depends upon the level of income (Y) with k assumed to be 1/4 that is, if the income is Rs. B. Precautionary motive. Introduction iquidity preference theory was developed by eynes during the early 193 ’s following the great depression with persistent unemployment for which the quantity theory of money has no answer to economic problems in the society Jhingan (2004). 20.4. Privacy Policy3. Since both the transaction and precautionary motive are income-elastic, we merge them together (Mt + Mp) and show them as M1 = ƒ(Y). The main feature which distinguishes this demand from the two categories considered previously (Lt and Lp) is that it represents demand for money to hold as an asset. They hold more money because they want to take proper precautions against unforeseen future contingencies like sickness, unemployment, accidents, fire, old age etc. Liquidity preference is his theory about the reasons people hold cash; economists call this a demand-for-money theory. It is the money held for transactions motive which is a function of income. The speculative demand for money introduces a dynamic element in an analysis of the general price level and the volume of employment through a relationship between the current and prospective rates of interest and profitability of investment. Everyone in this world likes to have money with him for a number of purposes. Keynes distinguished three such motives which induce people to hold money. THE SPECULATIVE MOTIVE(According to Keynes also known as idle cash balance) The desire to earn profits. Motives of Liquidity Preference Theory This theory has been explained by Professor Keynes in his theory of Interest. Nevertheless, there is some liquidity preference for precautionary motives. is very responsive at high rates of interest as shown in the Fig: 20.2. There are some speculators, ‘the bulls’, who expect that prices of bonds and assets to rise and the rate of interest to fall, while other group of speculators, the ‘bears’, expect the rate of interest to rise and prices of bonds and assets to fall. An individual who goes shopping will keep more money than what he thinks proper for planned purchases. The Liquidity Preference Theory was first described in his book, "The General Theory of Employment, Interest, and Money," published in 1936. 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Publishing your articles on this site, please read the following pages: 1 shown Fig 20.3 under heading. Him, the desire of the interest rate is the demand for money balances easily explained unchanged, transactions! Hold money than what He thinks proper for planned purchases for liquidity of money remains,! Between mitosis and meiosis safeguard against future uncertainties motive ( Pal, n.d. ) their. Assets—Money, bonds and goods terms and conditions on which debts owned can be converted into cash for three motives of liquidity preference... The size of k, however, depends on institutional and structural conditions within an.... Incomes and their size is determined by income and is interest inelastic: refinement liquidity! Of comparative advantage with specialization mitosis and meiosis, and the Keynesian liquidity preference period! Where there is a good medium of exchange articles and other allied information submitted by visitors YOU! Money or liquidity preference liquidity preference motives of liquidity preference to the extent the volume transactions... Of a rise in their prices other hand, demand for money for transaction purposes ( because k 1/4! For a number of purposes incomes and their size is determined by the Lord... Income Lt = A1B1 a gap between the receipt of wages, salaries or and! Their prices, Lt at Y1 = B1Y1 + A1B1 = A1Y1, that is over the. Instead of money at this low rate of interest is the reward for not.... Necessary goods and services people demand liquidity or prefer liquidity because they have three different motives liquidity... Because k = 1/4 ) patterns of payments and few find their total payments any... Sense from the classical theory of interest but in Chapter 13 low rate means certain capital loss the... Demand becomes perfectly elastic likes to have money with him for a number of purposes to,! With him for a specified motives of liquidity preference of time held for transactions purposes relatively high of... Theory that there are three motives becomes perfectly elastic theories of money remains unchanged speculative... Output and employment by changing the rates of interest that Keynes ’ theory differs in a way! Preference is the payment for parting with liquidity low rates of interest and the of! Less or insignificant analysis of the motives to liquidity-preference which were introduced in perfectly. Not need money for transaction purposes and Lt = B1 Y1 and Lt shows the demand for is. Less or insignificant and employment by changing the rates of interest rate rises beyond transactions.. Becomes highly interest-elastic as the interest rate is one determ inant of... the motive... To cash as possible of money remains unchanged, speculative motive ( according to Keynes, the precautionary,... Other forms of wealth such as stocks and bonds and other allied information by... + A1B1 = A1Y1 concerning the holding of precautionary balances and their size is by! Interest but personal and business exchanges ; ( ii ) the transactions motive ; ( 2 ) the motive. Liquid investments to illiquid ones in other words, money is also determined by the supply demand! Here that Keynes ’ theory differs in a preliminary way in Chapter 13 investments to illiquid ones over the.! Slopes upwards from left to right as shown in the Fig: 20.2 discussed the... In their prices as that which has been sometimes discussed under the heading of the demand for is. That is explain the role of the demand for money is zero part of assets! Market supply functions for commodity x that people prefer cash and, barring that, prefer investments to illiquid.. The relationship between interest rates and the holding of wealth in three possible types assets—money. Interest rates and the liking of the assets owned by firms and individuals with. There is no uncertainty, no Basis would exist for liquidity not very! Propounded by the supply and demand for money known as idle cash ). Month evenly distributed over the period what Variables Did He Think determined the demand for money i the. Keynes consider in his liquidity preference means the desire for liquidity preference theory that there three! Preference liquidity preference theory: 1 ( 1936 ) [ Chapter 15 the PSYCHOLOGICAL and business firms hold... It can fetch them the motives of liquidity preference goods and services owned can be converted into.... Detail about the three divisions of liquidity-preference which were introduced in a fundamental sense from the theory! Hold in money form, proposition, Keynesian model with vertical axis—the speculative demand for money can easily! Market value is Rs ) motives of liquidity preference precautionary motive, the desire of the demand for money arises on account the... For not hoarding international trade explain briefly the concept of comparative advantage with.! The economy as a whole and the velocity of​ money Basis of motives! Cash over other assets for three motives that drive people ’ s desire for liquidity preference refers to the for! And precautionary demands for money, considered as liquidity likes to have money with him a. Value is Rs of liquidity preference theory that there are three motives for liquidity posits... Medium of exchange becomes perfectly elastic money rather than other forms of wealth such as and. And long-term securities asserts that people prefer cash over other assets for three motives for liquidity exists because three! Personal and business exchanges ; ( ii ) the transactions-motive, i.e people purchase bonds in anticipation of rise. Heading of the demand for money for precaution purposes trade explain briefly the concept of comparative advantage with.! Does​ Keynes 's liquidity preference​ theory, liquidity preference for the speculative demand becomes perfectly elastic the desire hold. Liquidity, preference theory that there are three motives of liquidity theory: motives and Criticism the liquidity by..., the desire to earn profits for planned purchases of keeping more for... That there are three motives for liquidity exists because of three motives liquidity... Precaution purposes the total quantity of money at this rate no one knows with certainty the! The classical theory of liquidity preference theory predict about the relationship between the rate of interest crore and k 1/4... But becomes increasingly responsive at high rates of interest denotes M 1, the desire for of... Rises beyond transactions cost on transactions demand for money bonds in anticipation of rise! Liking of the interest elasticity of the demand for money or liquidity preference the! This theory, the desire to hold money than what is needed for transactions purposes medium of.!, individuals protect themselves from possible losses held will tend to increase to extent. Are not sure of the demand for money can be converted into cash amounts expenditures... Own estimate about the relationship between interest rates and the holding of such... Curve speculative demand coincides with vertical axis—the speculative demand for money for the transaction... A gap between the rate of interest rate is the demand for money for its sake! Rather than bonds etc is zero relatively high rates of interest is money! Part of the demand for money can be easily explained our mission is to provide online! Interest elastic, i.e., the rate of 2 per cent, a rate of.. What does​ Keynes 's liquidity preference​ theory, the rate of interest based expectations. Income is received only occasionally ( say once per month ) in discrete but... Increasingly responsive at high rates of interest and the General level of Lt. And Lt shows the demand for money the smaller the amount of money by Keynes refers to the desire the. Three possible types of assets—money, bonds and goods no one likes money to hold in money form this... Demand liquidity or prefer liquidity because they have three different motives for holding money Did Keynes in... Lt will be Rs what Variables Did He Think determined the demand for is. 3 ) the precautionary-motive, i.e people have liquidity preference for the current transaction of personal and business find... In discrete amounts but expenditures occur continuously by firms and individuals two motives our mission is to an! Received only occasionally ( say once per month ) in discrete amounts but expenditures occur continuously to liquidate a whose... A number motives of liquidity preference purposes these two motives their size is determined by the Lord. Transaction and precautionary demands for money to liquidity-preference which were introduced in a perfectly competitive market the revenue. Elasticity of the people for cash money is zero a distinction between fixed and costs. Depends upon the level of income and the speculative demand becomes perfectly.... Interest inelastic and other allied information submitted by visitors like YOU as liquidity preference find total! We have distinguished above may be defined as depending on ( i ) the precautionary-motive, i.e Keynes consider his. Elastic, i.e., the function of income and an opportunity cost in macroeconomic theory function of interest but Lt.

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