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1 Pearson Education 2011

Economics,
Arab World Edition
R. Glenn Hubbard, Anthony Patrick OBrien,
Ashraf Eid, Amany El Anshasy,

Chapter 20
Aggregate Demand and Aggregate
Supply Analysis

2 Pearson Education 2011


The Fortunes of Learning Objectives
Aramex Follow the 20.1 Identify the determinants of
aggregate demand and
Business Cycle distinguish between a
movement along the aggregate
demand curve and a
The global economic environment shift of the curve.
plays a crucial role in the
20.2 Identify the determinants of
development of the air freight aggregate supply and
industry, which has witnessed a distinguish between a
movement along the
huge boom in recent years in the short- run aggregate supply
Arab world. curve and a shift of the curve.

20.3 Use the aggregate demand and


aggregate supply model to
illustrate the difference between
short-run and long-run
macroeconomic equilibrium.

20.4 Use the dynamic aggregate


demand and aggregate supply
model to analyze
macroeconomic conditions.

APPENDIX Understand macroeconomic


schools of thought.

3 Pearson Education 2011


Learning Objective 20.1

Aggregate Demand
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Aggregate demand and aggregate supply model


A model that explains short-run fluctuations in real
GDP and the price level.

FIGURE 20.1
Aggregate Demand and
Aggregate Supply

4 Pearson Education 2011


The Model of Aggregate Demand
and Aggregate Supply
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

P
The price
level
SRAS

Short-
The model P1 Run
determines Aggregate
the eqm price Aggregate Supply
level Demand AD

and eqm Y
Y1
output
(real GDP). Real GDP, the
quantity of
output
The Aggregate-Demand (AD) Curve
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

P
The AD curve
shows the P2
quantity of
all g&s
demanded
P1
in the economy
at any given AD
price level.
Y
Y2 Y1
Learning Objective 20.1

Aggregate Demand
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Aggregate demand curve A curve that shows


the relationship between the price level and the
quantity of real GDP demanded by households,
firms, and the government.

Short-run aggregate supply curve A curve that


shows the relationship in the short run between
the price level and the quantity of real GDP
supplied by firms.

7 Pearson Education 2011


Learning Objective 20.1

Aggregate Demand
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Why Is the Aggregate Demand Curve Downward Sloping?


GDP has four components: consumption (C),
investment (I), government purchases (G), and net
exports (NX). If we let Y stand for GDP, we can write
the following:

Y = C + I + G + NX

The Wealth Effect: How a Change in the Price Level


Affects Consumption

The impact of the price level on consumption is called


the wealth effect.

8 Pearson Education 2011


Learning Objective 20.1

Aggregate Demand
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Why Is the Aggregate Demand Curve Downward Sloping?


The Interest-Rate Effect: How a Change in the Price
Level Affects Investment

The impact of the price level on investment is


known as the interest-rate effect.

The International-Trade Effect: How a Change in the


Price Level Affects Net Exports

The impact of the price level on net exports is


known as the international-trade effect.

9 Pearson Education 2011


The Wealth Effect (P and C )
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Suppose P rises.
The dollars people hold buy fewer g&s,
so real wealth is lower.
People feel poorer.
Result: C falls.
The Interest-Rate Effect (P and I )
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Suppose P rises.
Buying g&s requires more dollars.
To get these dollars, people sell bonds or other assets.
This drives up interest rates.
Result: I falls.
(Recall, I depends negatively on interest rates.)
The Exchange-Rate Effect (P and NX )
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Suppose P rises.
U.S. interest rates rise (the interest-rate effect).
Foreign investors desire more U.S. bonds.
Higher demand for $ in foreign exchange market.
U.S. exchange rate appreciates.
U.S. exports more expensive to people abroad, imports
cheaper to U.S. residents.
Result: NX falls.
The Slope of the AD Curve: Summary
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

An increase in P P
reduces the quantity
of g&s demanded
P2
because:
the wealth effect
(C falls)
P1
the interest-rate
AD
effect (I falls)
the exchange-rate Y
effect (NX falls) Y2 Y1
Learning Objective 20.1

Aggregate Demand
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Shifts of the Aggregate Demand Curve versus


Movements Along It

An important point to remember is that the aggregate


demand curve tells us the relationship between the
price level and the quantity of real GDP demanded,
holding everything else constant.

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Learning Objective 20.1

Aggregate Demand
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

The Variables That Shift the Aggregate Demand Curve

The variables that cause the aggregate demand


curve to shift fall into three categories:

Changes in government policies


Changes in the expectations of
households and firms
Changes in foreign variables

15 Pearson Education 2011


Learning Objective 20.1

Aggregate Demand
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

The Variables That Shift the Aggregate Demand Curve


Changes in Government Policies

Monetary policy The actions the Federal


Reserve takes to manage the money
supply and interest rates to pursue
macroeconomic policy objectives.

Fiscal policy Changes in federal taxes


and purchases that are intended to achieve
macroeconomic policy objectives, such as
high employment, price stability, and high
rates of economic growth.

16 Pearson Education 2011


Learning Objective 20.1

Aggregate Demand
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

The Variables That Shift the Aggregate Demand Curve


Changes in the Expectations of Households and Firms
If households become more optimistic about their
future incomes, they are likely to increase their
current consumption.

Changes in Foreign Variables


If firms and households in other countries buy
fewer U.S. goods or if firms and households in the
United States buy more foreign goods, net
exports will fall, and the aggregate demand curve
will shift to the left.

17 Pearson Education 2011


Learning Objective 20.1

Making
In a Global Economy, How Can You Tell
the
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Connection the Imports from the Domestic Goods?

While the Kushari dish or falafel sandwich are


obviously made in Egypt, the Big Mac, the
Cheesy Bites pizza, and the Zinger dinner box
are not made in the US.

18 Pearson Education 2011


Learning Objective 20.1

Solved Problem 20-1


Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Movements along the Aggregate Demand Curve


versus Shifts of the Aggregate Demand Curve

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Learning Objective 20.1

Aggregate Demand
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

The Variables That Shift the Aggregate Demand Curve

Table 20-1
Variables That Shift the Aggregate Demand Curve

20 Pearson Education 2011


Learning Objective 20.1

Aggregate Demand
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

The Variables That Shift the Aggregate Demand Curve


Table 20-1
Variables That Shift the Aggregate Demand Curve (continued)

21 Pearson Education 2011


The Aggregate-Supply (AS ) Curves
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

The AS curve shows P LRAS


the total quantity of
g&s firms produce SRAS
and sell at any given
price level.

AS is:
upward-sloping
in short run
vertical in Y
long run
The Long-Run Aggregate-Supply Curve (LRAS)
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

The natural rate of P LRAS


output (YN) is the
amount of output
the economy produces
when unemployment
is at its natural rate.
YN is also called
potential output
or
full-employment Y
YN
output. (this is from
chapter 12)
Why LRAS Is Vertical
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

YN determined by the P LRAS


economys stocks of
labor, capital, and
natural resources,
and on the level of P2
technology.
P1
An increase in P
does not affect
any of these,
Y
so it does not YN
affect YN.
(Classical dichotomy)
Why the LRAS Curve Might Shift
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

P LRAS1 LRAS2
Any event that
changes any of the
determinants of YN
will shift LRAS.
Example:
Immigration
increases L,
causing YN to rise.
Y
YN YN
Why the LRAS Curve Might Shift
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Changes in L or natural rate of unemployment


Immigration
Baby-boomers retire
Govt policies reduce natural u-rate
Changes in K or H
Investment in factories, equipment
More people get college degrees
Factories destroyed by a hurricane
Why the LRAS Curve Might Shift
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Changes in natural resources (N)


Discovery of new mineral deposits
Reduction in supply of imported oil
Changing weather patterns that affect agricultural production
Changes in technology (A)
Productivity improvements from technological progress
Using AD & AS to Depict
Long-Run Growth and Inflation
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

LRAS2010
Over the long run, P LRAS2000
tech. progress shifts LRAS1990
LRAS to the right

and growth in the P2010


money supply
P2000
shifts AD to the
AD2010
right. P1990
Result:
ongoing AD2000
inflation and AD1990
Y
growth in Y1990 Y2000 Y2010
output.
Short Run Aggregate Supply (SRAS)
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

The SRAS curve P


is upward sloping:
Over the period SRAS
of 12 years, P2
an increase in P
causes an P1
increase in the
quantity of g &
s supplied. Y
Y1 Y2

The positive slope of the SRAS is the key to


understanding short-run fluctuations.
Why the Slope of SRAS Matters
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

P LRAS
If AS is vertical,
fluctuations in AD Phi
SRAS
do not cause Phi
fluctuations in output
or employment.
ADhi
If AS slopes up, Plo
then shifts in AD AD1
Plo
do affect output ADlo
Y
and employment. Ylo Y1 Yhi
Three Theories of SRAS
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

In each,

some type of market imperfection (maybe


better, some type of confusion)
result:
Output deviates from its natural rate
when the actual price level deviates
from the price level people expected.
1. The Sticky-Wage Theory
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Imperfection:
Nominal wages are sticky in the short run,
they adjust sluggishly.
Due to labor contracts, social norms
Firms and workers set the nominal wage in advance based on
PE, the price level they expect to prevail.
1. The Sticky-Wage Theory
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

If P > PE,
revenue is higher, but labor cost is not.
Production is more profitable,
so firms increase output and employment.
Hence, higher P causes higher Y,
so the SRAS curve slopes upward.
2. The Sticky-Price Theory
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Imperfection:
Many prices are sticky in the short run.
Due to menu costs, the costs of adjusting prices.
Examples: cost of printing new menus,
the time required to change price tags
Firms set sticky prices in advance based
on PE.
2. The Sticky-Price Theory
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Suppose the Fed increases the money supply


unexpectedly. In the long run, P will rise.
In the short run, firms without menu costs can
raise their prices immediately.
Firms with menu costs wait to raise prices.
Meanwhile, their prices are relatively low,
which increases demand for their products,
so they increase output and employment.
Hence, higher P is associated with higher Y,
so the SRAS curve slopes upward.
3. The Misperceptions Theory
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Imperfection:
Firms may confuse changes in P with changes
in the relative price of the products they sell.
If P rises above PE, a firm sees its price rise
before realizing all prices are rising.
The firm may believe its relative price is rising,
and may increase output and employment.
So, an increase in P can cause an increase in Y,
making the SRAS curve upward-sloping.
What the 3 Theories Have in Common:
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

In all 3 theories, Y deviates from YN when


P deviates from PE.

Y = YN + a (P PE)
Output Expected
price level
Natural
rate of
a > 0,
measures Actual
output price
(long-run) how much Y
responds to level
unexpected
changes in P
What the 3 Theories Have in Common:
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Y = YNN + a (P PEE)
P

SRAS
When P > PE

the expected
PE
price level

When P < PE

Y
YN
Y < YN Y > YN
Learning Objective 20.2

Aggregate Supply
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

The Long-Run Aggregate Supply Curve


FIGURE 20.2
The Long-Run Aggregate
Supply Curve

A curve that shows the


relationship in the long
run between the price
level and the quantity
of real GDP supplied.

39 Pearson Education 2011


Learning Objective 20.2

Aggregate Supply
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

The Short-Run Aggregate Supply Curve

The three most common explanations as to why a short-


run aggregate supply curve slopes upward include:

Contracts make some wages and prices sticky.


Firms are often slow to adjust wages.
Menu costs make some prices sticky.

Menu costs The costs to


firms of changing prices.

40 Pearson Education 2011


Learning Objective 20.2

Aggregate Supply
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Shifts of the Short-Run Aggregate Supply Curve versus


Movements Along It

It is important to remember the difference


between a shift in a curve and a movement
along a curve.

Variables That Shift the Short-Run Aggregate Supply Curve


Increases in the Labor Force and in the Capital Stock

Technological Change
Expected Changes in the Future Price Level

41 Pearson Education 2011


Learning Objective 20.2

Aggregate Supply
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Variables That Shift the Short-Run Aggregate Supply Curve


Expected Changes in the Future Price Level

FIGURE 20.3
How Expectations of
the Future Price Level
Affect the Short-Run
Aggregate Supply

42 Pearson Education 2011


Learning Objective 20.2

Aggregate Supply
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Variables That Shift the Short-Run Aggregate Supply Curve


Adjustments of Workers and Firms to Errors in Past
Expectations about the Price Level

Unexpected Changes in the Price of an Important


Natural Resource

Supply shock An unexpected


event that causes the short-run
aggregate supply curve to shift.

43 Pearson Education 2011


Learning Objective 20.2

Aggregate Supply
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Variables That Shift the Short-Run Aggregate Supply Curve

Table 20-2
Variables That Shift the Short-Run Aggregate Supply Curve

44 Pearson Education 2011


Learning Objective 20.2

Aggregate Supply
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Variables That Shift the Short-Run Aggregate Supply Curve

Table 20-2
Variables That Shift the Short-Run Aggregate Supply Curve (continued)

45 Pearson Education 2011


Learning Objective 20.3

Macroeconomic Equilibrium
in the Long Run and the Short Run
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

FIGURE 20.4
Long-Run Macroeconomic
Equilibrium

46 Pearson Education 2011


Learning Objective 20.3

Macroeconomic Equilibrium
in the Long Run and the Short Run
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Recessions, Expansions, and Supply Shocks

Because the full analysis of the aggregate demand and


aggregate supply model can be complicated, we begin
with a simplified case, using two assumptions:

1 The economy has not been experiencing any


inflation. The price level is currently 100, and
workers and firms expect it to remain at 100
in the future.
2 The economy is not experiencing any long-run
growth. Potential real GDP is $10.0 trillion
and will remain at that level in the future.

47 Pearson Education 2011


Learning Objective 20.3

Macroeconomic Equilibrium
in the Long Run and the Short Run
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Recessions, Expansions, and Supply Shocks


Recession
FIGURE 20.5
The Short-Run and
Long-Run Effects of a
Decrease in Aggregate
Demand

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Learning Objective 20.3

Macroeconomic Equilibrium
in the Long Run and the Short Run
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Recessions, Expansions, and Supply Shocks


Expansion
FIGURE 20.6
The Short-Run and
Long- Run Effects of
an Increase in
Aggregate Demand

49 Pearson Education 2011


Learning Objective 20.3

Macroeconomic Equilibrium
in the Long Run and the Short Run
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Recessions, Expansions, and Supply Shocks


Supply Shock

Stagflation A combination
of inflation and recession,
usually resulting from a
supply shock.

50 Pearson Education 2011


Learning Objective 20.3
Macroeconomic Equilibrium
in the Long Run and the Short Run
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Recessions, Expansions, and Supply Shocks


Supply Shock
FIGURE 20.7
The Short-Run and Long-Run Effects of a Supply
Shock

51 Pearson Education 2011


Learning Objective 20.4

A Dynamic Aggregate Demand


and Aggregate Supply Model
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

We can create a dynamic aggregate demand and


aggregate supply model by making three changes to
the basic model.
Potential real GDP increases continually,
shifting the long-run aggregate supply curve to
the right.
During most years, the aggregate demand
curve will be shifting to the right.
Except during periods when workers and firms
expect high rates of inflation, the short-run
aggregate supply curve will be shifting to the
right.

52 Pearson Education 2011


Learning Objective 20.0

A Dynamic Aggregate Demand


FIGURE 20.8
and Aggregate Supply Model
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

A Dynamic Aggregate Demand


and Aggregate Supply Model

53 Pearson Education 2011


Learning Objective 20.4

A Dynamic Aggregate Demand


and Aggregate Supply Model
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

What Is the Usual Cause of Inflation?


FIGURE 20.9
Using Dynamic Aggregate
Demand and Aggregate
Supply to Understand
Inflation

54 Pearson Education 2011


Learning Objective 20.4

A Dynamic Aggregate Demand


and Aggregate Supply Model
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

The Slow Recovery from the Recession of 2009

The recession of 2009 was caused The recession was


caused by the financial crises that started in the US and
expanded to the whole world by the end of 2008.
A decline in global aggregate demand and in the
Arab world

A decline in the world demand for oil led to a large


drop in its prices
Recessionary trends in the Arab world economies

55 Pearson Education 2011


Learning Objective 20.4

A Dynamic Aggregate Demand


and Aggregate Supply Model
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

The Slow Recovery from the Recession of 2009

FIGURE 20.10
Using Dynamic Aggregate
Demand and Aggregate
Supply to Understand the
Recovery from the 2009
Recession

56 Pearson Education 2011


Learning Objective 20.4

Making
the Saudis Slow Economic Recovery
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Connection

Following a stagnant and a difficult year in 2009,


Saudi Arabias economic recovery in 2010 and 2011
seems to follow a gradual but steady path of an
accelerating growth performance.
During a recession, businesses suffer
from slower demand and less
consumer spending. As a result,
investment shrinks.

57 Pearson Education 2011


Learning Objective 20.4

A Dynamic Aggregate Demand


and Aggregate Supply Model
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

The More Rapid Recovery of 20102011

FIGURE 20.11
Using Dynamic Aggregate
Demand and Aggregate
Supply to Understand the
More Rapid Recovery of
20102011

58 Pearson Education 2011


Learning Objective 20.4

Solved Problem 20-4


Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Showing the Oil Shock of 19741975 on a Dynamic


Aggregate Demand and Aggregate Supply Graph

59 Pearson Education 2011


Learning Objective 24.4

Making
the Can FedEx and the US Economy Withstand High
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Connection Oil Prices?

FedExs trucks and jets have become more fuel efficient.

60 Pearson Education 2011


An Inside LOOK How FedEx Middle East Weathered
the Recent Global Recession
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Freight Carrier Express Strategy

FedEx in the Middle East met the challenges of the global


recession. FedExs strategy to work around the recession was
twofold. First, they focused on consumer needs, providing more
delivery options and economy services at times the consumer
is cutting expenses. The second was to cut all possible costs, in
order to improve profitability despite a drop in demand.

The U.S. economic expansion from the first quarter of 2006 to


the first quarter of 2007.

61 Pearson Education 2011


Key Terms
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Aggregate demand and aggregate supply model


Aggregate demand curve
Fiscal policy
Long-run aggregate supply curve
Menu costs
Monetary policy
Short-run aggregate supply curve
Stagflation
Supply shock

62 Pearson Education 2011


Appendix
Macroeconomic Schools of Thought
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

Keynesian revolution The name given to the widespread


acceptance during the 1930s and 1940s of John Maynard Keyness
macroeconomic model.

These alternative schools of thought use models that differ


significantly from the standard aggregate demand and aggregate
supply model. We can briefly consider each of the three major
alternative models:

1 The monetarist model


2 The new classical model
3 The real business cycle model

63 Pearson Education 2011


Appendix
Macroeconomic Schools of Thought
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

The Monetarist Model

The monetarist modelalso known as the neo-Quantity Theory of


Money modelwas developed beginning in the 1940s by Milton
Friedman, an economist at the University of Chicago who was
awarded the Nobel Prize in Economics in 1976.

Monetary growth rule A plan for increasing the


quantity of money at a fixed rate that does not respond
to changes in economic conditions.
Monetarism The macroeconomic theories of Milton
Friedman and his followers; particularly the idea that
the quantity of money should be increased at a
constant rate.

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Appendix
Macroeconomic Schools of Thought
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

The New Classical Model

The new classical model was developed in the mid-1970s by a


group of economists including Nobel laureate Robert Lucas of the
University of Chicago, Thomas Sargent of New York University,
and Robert Barro of Harvard University.

New classical macroeconomics The macroeconomic


theories of Robert Lucas and others, particularly the
idea that workers and firms have rational expectations.

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Appendix
Macroeconomic Schools of Thought
Chapter 20: Aggregate Demand and Aggregate Supply Analysis

The Real Business Cycle Model

Beginning in the 1980s, some economists, including Nobel


laureates Finn Kydland of Carnegie Mellon University and Edward
Prescott of Arizona State University, argued that Lucas was correct
in assuming that workers and firms formed their expectations
rationally and that wages and prices adjust quickly to supply and
demand but wrong about the source of fluctuations in real GDP.

Real business cycle model A macroeconomic model


that focuses on real, rather than monetary, causes of
the business cycle.

66 Pearson Education 2011


Chapter 20: Aggregate Demand and Aggregate Supply Analysis

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