For brevity, the taking of goods and services off the market will be referred to here as absorption. Absorption then equals the sum of consumption plus investment as usually defined including in investment any change in the holding of inventories. If a devaluation is to affect the foreign balance, it can do so in only two ways: 1 It can lead to a change in the production of goods and services in the country; this change will have associated with it an induced change in the absorption of goods and services so that the foreign balance will be altered by the difference between the change in income and the income-induced change in absorption.
In order to simplify the discussion, any factors affecting the foreign balance of a country other than those connected with trade in goods and services will be ignored. Also, it will be assumed that there are no restrictions on trade and payments, although that assumption is not necessary for the validity of the subsequent analysis.
Furthermore, only the simplest forms of the various relationships involved will be considered. For example, only one price level will be considered, and the change in that level will be denoted by p. The reader who wishes to think of a more complex and realistic model may consider p as denoting a whole set of price changes that might be represented by a vector.
Similarly, y will denote the change in the aggregate net production of goods and services, i. A starting point is the identity that the foreign balance, B , is equal to the difference between the total production of goods and services, Y , 3 and the total absorption of goods and services, A:. Changes in these quantities may be denoted by the corresponding small letters, so that is our fundamental identity.
It indicates that the change in the foreign balance equals the difference between the change in output and the change in absorption of goods and services. It shows that the first question to be investigated is how the devaluation will affect the two terms, y and a. The above relationships hold, of course, both in real and in money terms. The present discussion will deal only with real quantities, not with money values. Account may first be taken of the fact that the absorption of goods and services depends, at least in part, on real income, which itself is equal to the output of goods and services.
Absorption may also depend on the price level, or other factors related to the devaluation, so that. The term d may be called the direct effect of the devaluation on absorption. It expresses whatever tendency there may be for the devaluation to induce a change in the amount of real absorption at any given level of real income.
Equation 2 therefore states that the change in the absorption of goods and services in real terms as a result of devaluation is made up of two parts.
The first, cy , is the change in real consumption plus real investment that is induced by the change in real income that results from the devaluation. The other part, d , is the change in absorption which results other than through the income effect.
This formulation is useful in that it directs the investigation to three basic questions: How does the devaluation affect income? How does a change in the level of income affect absorption, i. How does the devaluation directly affect absorption at any given level of income, i. In order to analyze these questions in precise terms, the entire economic structure of the devaluing country and of the rest of the world would have to be considered.
Such an analysis would be far more complicated than is desirable for the presentation of the main ideas of this paper.
Consequently, what follows is a summary of these main ideas, rather than a precise formulation of the relationships. The principal effect of a devaluation on income is associated with the increased exports of the devaluing country and the induced stimulation of domestic demand through the familiar multiplier relationship, provided there are unemployed resources.
These considerations are familiar in the literature. It must be emphasized that the net effect of the recovery of income and production on the foreign balance is not the total amount of additional production induced, but merely the difference between that amount and the induced increase in absorption.
This difference between the real production or income and the real expenditure on goods and services may be termed real hoarding. The foreign balance is, by the fundamental identity, equal to the aggregate real hoarding of the economy as a whole. The income-induced change in the balance, b , is accordingly equal to the income-induced change in real hoarding, i.
The existence of the business cycle makes it plausible that c may be greater than unity, that an increase in income may stimulate an even greater increment in the absorption of goods and services into consumption and investment. Many of the current theories of the business cycle do depend on the assumption that c is greater than unity. If c is equal to or greater than unity, the foreign balance will not be improved as a result of the increased output.
Under such circumstances, the devaluation might be effective in stimulating recovery but not in improving the foreign balance except possibly through direct effects, which will be considered below. At any rate, under conditions of unemployment, devaluation may be expected to exert a favorable effect on production and employment.
This fact became evident in the devaluations of the thirties, and was recognized even before the promulgation of the Keynesian theory, though not in so systematic or analytic a framework. Of course, to the extent that the additional exports of the devaluing country displace those of its competitors, the levels of production and income in the competitor countries will be adversely affected.
From the point of view of a devaluing country that has unemployed resources, the effect on income, as well as the favorable effect on the balance of payments if c is less than unity, must constitute the most attractive potentiality of a devaluation. If the country is at full employment, this potentiality does not exist and the effects of a devaluation must depend on the more tenuous and less attractive direct effects on absorption.
Another income effect frequently considered as influencing the foreign balance is that of the terms of trade. It is usually presumed, frequently with justification, that a devaluation will result in a decline of export prices in foreign currency greater than the decline of import prices in foreign currency.
There may be some compensation, though probably only to a minor degree, if imports greatly exceed exports prior to the devaluation. Thus, if before the devaluation the country concerned was importing twice as much as it was exporting, and if as a result of the devaluation the fall in foreign prices of exports is 2 per cent and of imports 1 per cent, the deficit in foreign currency would be unchanged if the physical values of imports and exports were unchanged.
It may, however, be assumed that the normal result of a devaluation will be such a deterioration of the terms of trade of the devaluing country as to make the balance of payments deteriorate by the amount t. A fallacious argument, frequently encountered, is that a deterioration of the terms of trade on account of devaluation will improve the foreign balance since it reduces the real income of the country and hence the demand for imports.
It is true that the reduced income associated with a deterioration of the terms of trade will reduce the demand for imports as well as for domestic goods. Thus the decline in income, t , resulting from the changed terms of trade will induce a reduction of absorption by the amount ct , which will permit an equivalent improvement in the foreign balance partly through the direct reduction of imports included in ct and partly through the eventual transfer to the production of exports or of import substitutes of the resources formerly used to produce the domestic components of ct.
The effects of the deterioration of the terms of trade accordingly will be, after resources are transferred, an improvement of the amount, ct. But the entire deterioration, t , of the national income as a result of the changed terms of trade is initially a reduction in the foreign balance. That is, the change of the terms of trade initially imposes a reduction, t, in the foreign balance and then has the effect of stimulating an improvement, ct , so that the change in the balance associated with the initial terms of trade effect on income, t , is t-ct or 1- c t.
This might have been seen directly from equation 3. If t is negative, as assumed, and if c is less than unity, then a deterioration in the terms of trade also implies a deterioration in the foreign balance. Only if c is greater than unity will the adverse terms of trade effect improve the foreign balance. The aggregate income effects may then be expressed as 1- c multiplied by the change of income.
That change of income will have two components. One, presumably positive, is the idle resources effect, i. The other, presumably negative, is the effect on income of the change in the terms of trade.
The resulting change in income, y , will induce a change in absorption, cy , so that it will, according to equation 1 , result in a change of the foreign balance equal to y-cy or 1- c y.
If there is initially full employment, or if c is almost unity or greater than unity, the principal favorable influence of a devaluation on the foreign balance is through the direct effect on absorption. This direct effect is largely associated with a tendency for a high or rising price level to discourage consumption or investment out of a given level of real income. It is important to recognize that this effect is not connected with any tendency for higher prices to force a reduction of consumption or investment out of a given money income.
That would be an effect through real income, since if prices go up relative to money income, real income goes down. Except for the terms of trade effect on income, the real income of the devaluing country should not be expected to decline; at full employment, money income and money prices can be expected to move together. The direct effect on absorption is any influence toward lower real expenditure as money income and money prices rise together as a result of the devaluation.
In order most clearly to illustrate the nature of the forces behind d , the direct effect on absorption, certain assumptions which imply that all other effects are absent can be made. Accordingly, assume that the devaluing country is at full employment so that real income produced cannot be increased as a result of devaluation.
Furthermore, assume that the foreign supply of imports and the foreign demand for exports are perfectly elastic, so that the foreign currency prices of imports and exports, and hence the terms of trade, will be unchanged.
Thus there will be no income effects, either through increased production or through a change in the terms of trade. The higher import and export prices in domestic currency resulting from devaluation will initially induce an attempt by individuals and enterprises in the devaluing country to shift their demand from imports to the home market and to export more.
If there were no direct absorption effect, domestic prices would continue to rise until there was no longer any tendency to substitute domestic goods for imports, or to try to export more, and there would be no change of the foreign balance as a result of the devaluation.
The relationship involved may be illustrated by a crude example. Suppose, under the assumed conditions of full employment and perfectly elastic foreign supply and demand, that there is a 10 per cent devaluation and an elasticity of direct absorption of 0. This would mean that a 1 per cent increase in the general price level would induce a 0. It may also be assumed that the substitutability of domestic goods for imports in consumption, and of resources as between the production of domestic goods and exports, is such as to link the domestic price level to the prices of foreign goods by a factor of 0.
Then the devaluation would lead to a reduction of absorption by one-half of one per cent of total absorption. In terms of the conventional analysis, the inelasticity of domestic supply of exports and of import substitutes reduces the effect of the devaluation in spite of the perfect elasticities of foreign supply and demand.
At full employment, the elasticity of domestic supply for import substitutes and exports taken together must be just another way of expressing the direct absorption effect. It is frequently taken for granted that, even when the devaluing country is at full employment, a devaluation will lead to increased exports and reduced imports. If it does so, then clearly domestic absorption will have been reduced.
The question to be explored is why, with a given real income, when money incomes and prices rise in the same proportion there should be a reduction of real consumption or investment. The direct absorption effect can be divided into a cash balance effect, an income redistribution effect, a money illusion effect, and possibly into other, miscellaneous direct absorption effects. The cash balance effect is perhaps the best known of the direct absorption effects.
If the money supply is inflexible, and if moneyholders desire to maintain cash holdings of a certain real value, they must, as prices rise, accumulate more cash. This will require a reduction in their real expenditures relative to their real incomes.
It might be possible for any individual to increase his cash holdings by selling other assets, but this is clearly impossible for the country as a whole as long as the banking system or government does not create more money, except to the extent that goods or services may be sold abroad and the domestic money supply thereby increased. Capital movements are ruled out here; if they were allowed they might change or eliminate the cash balance effect.
One result of the attempt to maintain real cash balances by increasing their money amounts while prices rise may be to drive down the prices of assets, i. This in turn might have some effect on real consumption or investment relative to real income: thus the cash balance effect may operate directly on the income-expenditure relationship through the foregoing of expenditure in order to build up cash, or indirectly through the rate of interest as the result of an attempt to shift from other assets into cash—an attempt that can be discouraged only by a rise in the rate of interest.
Clearly, one of the most important components of the direct absorption effect would be the cash balance effect. A hypothetical example applied to the United Kingdom may illustrate the possible magnitude of that effect.
It is possible that the reduction of absorption on account of the cash balance effect, or of the other direct absorption effects, might be directed toward certain domestic goods and services, from whose production it is not easy to transfer resources to the production of exports or import substitutes; therefore, some unemployment might result.
The results of this unemployment might then be traced throughout the economy. If c is less than one, the net result of this adverse effect on income produced would be a deterioration of the foreign balance which would tend to counteract the improvement from the direct absorption effects. It is pointed out below that, before any of the analysis of this paper is applied to a practical case, it is necessary to abandon the oversimplification here adopted and to recognize that y, a, p , and c are sets of quantities, i.
The economic content of this fact is that it will make a difference, in view of immobility of resources and other imperfections, in what sector of the economy a particular reduction of absorption, or change of income, takes place. The redistribution of income effect is also well recognized. There may be a long lag of wages behind prices, and profits might therefore gain at the expense of wages as a result of the devaluation.
Rising prices will transfer income from fixed money income groups to the rest of the economy. Taxes, at least in advanced countries, can be expected to take a larger share of a given real income when the price level is higher.
To the extent that income is shifted from those with a high marginal propensity to absorb to those with a low propensity, the foreign balance will be improved by the devaluation. It must be remembered, however, that absorption includes both consumption and investment, so that it is by no means certain that a shift to profits will lead to reduced absorption. Although the proportion of any increment of income consumed by the profit recipient may be smaller than the proportion consumed by the wage earner, the higher profits may stimulate investment demand.
The government can, in advanced countries, usually be expected to have a low marginal propensity to absorb, so that the tax shift might be a significant factor influencing the relationship of absorption to income, and so affecting the foreign balance. The money illusion may contribute a favorable effect to a devaluation if it actually leads people to pay more attention to money prices than to money incomes.
If at higher prices people choose to buy and consume less even though their money income has increased in proportion, over and above what can be attributed to the cash balance effect, the result on the balance of payments will be favorable. But rising money incomes and rising prices may actually operate in the opposite manner; for example, annual savings may be calculated in money terms and may fail to rise in proportion to money incomes and prices.
There may be other direct absorption effects, some working toward a favorable, others toward an unfavorable, change in the foreign balance. Expectations of price rises may be inspired, leading to increased absorption with adverse effects on the foreign balance, at least in the short run.
If investment goods come largely from abroad, investment may be much less attractive after the devaluation than before because of the rise in the domestic price of investment goods, provided no close substitutes are produced domestically.
More generally, the goods imported may be such that when the domestic prices rise, the domestic purchasers cut their expenditures on those goods but save or hoard the difference, rather than shift the expenditures to other goods. The importance of such a tendency in any actual case is open to doubt, but it is a theoretical possibility. Many of the direct absorption effects may be transitory.
Thus the money supply may respond to the increased demand for cash balances, so that the cash balance effect may gradually disappear or be counterbalanced by additional absorption financed by credit creation. Similarly, some of the income-distribution effects are associated with lags, but the lagged income may eventually catch up, e. Other effects depend on dynamic movements, on rising prices rather than on high prices. As the rise in prices comes to a halt, these effects will tend to disappear.
Furthermore, some of the effects may be non-proportional. A small devaluation may take advantage of the money illusion, or of wage inertia; a large devaluation may shatter the money illusion, or impart a dynamic momentum to the wage inertia, or impart a dynamic momentum to the wage inertia, or lead to modifications of tax rates, etc. In general, then, many of the effects of a devaluation on the balance of payments through the direct absorption effects may be expected to be transitory and non-proportional.
It does not necessarily follow that, in the absence of unemployment, a devaluation cannot have a strong influence on the balance of payments; that depends on the strength of the various effects discussed above. It would seem to be much more effective to operate on absorption directly through monetary and credit policy—limitation of government expenditures, of private investment and, possibly, of private consumption—provided these can be brought to bear on the foreign balance without adversely affecting income and employment.
This practical conclusion is not, however, the main conclusion of this paper. The main conclusion is that the most fruitful approach to the general problem of obtaining a satisfactory foreign balance, and in particular of appraising the effects on the foreign balance of a devaluation, is via the analysis of the income-absorption relationship.
It is theoretically possible to obtain the same answers in terms of supply and demand elasticities, but one is more likely to be misled.
It seems more in accord with the realities of the situation to recognize that, if the foreign balance is to be improved, the community as a whole must reduce its absorption of goods and services relative to its income. The inquiry can then best follow the line of asking who is to cut his absorption relative to his income, or what is to be the shift of income from those who, on the margin, absorb more to those who absorb less.
Supply and demand conditions, in the sense of partial elasticities, may be useful tools in this analysis. But the total elasticities, for which the conventional formulas alone are valid, are not only poor tools; they may mislead, or at least obscure the analysis. If an improvement of the foreign balance is required, it may possibly be achieved either through a devaluation or through some other method of reducing absorption relative to production.
The general alternative to devaluation is sometimes referred to as deflation, but that term has a narrower connotation than it is desirable to give to the alternatives to devaluation.
These alternatives, which may for brevity be referred to as disabsorption, may be characterized as the discouragement of absorption relative to income by means other than devaluation. Disabsorption may be attained through monetary policy, as for example, by discouraging investment and consumption through tightening credit.
It may be achieved by direct controls, such as investment licensing or rationing of consumers goods. It may be applied over the whole economy, as in the form of a sales tax or income tax, or in selected spheres, as in the form of investment licensing or import controls. The means to disabsorption are many and varied, but they may all be characterized as domestic measures calculated to change the relationship of absorption to income, and hence to affect the foreign balance.
An analysis of the relative advantages, from the point of view of a single country, of devaluation and trade restrictions has been presented elsewhere.
It can be extended to any other domestic measure for achieving a given balance of trade at full employment. Measures tending to reduce imports are of benefit to the country concerned as long as the relative domestic welfare value of import goods relative to export goods does not exceed the marginal terms of trade, i. When consideration is given to measures to improve the foreign balance under conditions of widespread unemployment, the above criterion must be so modified as to be abandoned for all practical purposes.
That criterion is based on the proposition that, if the marginal rate of exchange of export goods for import goods in the foreign market is less favorable than their domestic welfare values, it would pay to cut back on imports and thus gain a greater welfare value in the export goods saved for the domestic economy. But if the resources used to make those export goods would, under those conditions, become unemployed, then there would be no gain from the restriction but rather a considerable loss.
It is generally recognized that under conditions of widespread unemployment a domestic expansion policy is appropriate.
Any adverse effects on the foreign balance can, except in extreme cases of inelasticity of foreign demand and supply, be appropriately handled by devaluation rather than by disabsorption under such circumstances. Disabsorption becomes an attractive policy only as full employment is approached.
If disabsorption of a general nature, say through a broad deflationary policy, should lead from full employment to the idleness of certain resources which cannot be expected to be transferred to the production of exports or import substitutes, it is to that extent undesirable. It is well recognized that when deflation leads to unemployment it is an undesirable measure for improving the foreign balance.
Other means, such as import restriction or devaluation, would be preferable. In actual practice, therefore, the choice between devaluation and disabsorption will be affected not only by the considerations of the terms of trade on which the above criterion is based, but more immediately by considerations of other effects of any particular measure on the domestic economy.
Considerations of the desirability of the resulting changes in the distribution of income as among individuals are ignored here, although in practice these considerations may be important and sometimes governing.
A weak domestic currency makes a nation's exports more competitive in global markets, and simultaneously makes imports more expensive. Higher export volumes spur economic growth , while pricey imports also have a similar effect because consumers opt for local alternatives to imported products. This improvement in the terms of trade generally translates into a lower current account deficit or a greater current account surplus , higher employment, and faster GDP growth.
The stimulative monetary policies that usually result in a weak currency also have a positive impact on the nation's capital and housing markets, which in turn boosts domestic consumption through the wealth effect. It is worth noting that a strategic currency devaluation does not always work, and moreover may lead to a 'currency war' between nations. Competitive devaluation is a specific scenario in which one nation matches an abrupt national currency devaluation with another currency devaluation.
In other words, one nation is matched by a currency devaluation of another. This occurs more frequently when both currencies have managed exchange-rate regimes rather than market-determined floating exchange rates.
Even if a currency war does not break out, a country should be wary about the negatives of currency devaluation. Currency devaluation may lower productivity, since imports of capital equipment and machinery may become too expensive. Below, we look at the three top reasons why a country would pursue a policy of devaluation:.
On a world market, goods from one country must compete with those from all other countries. Car makers in America must compete with car makers in Europe and Japan. If the value of the euro decreases against the dollar, the price of the cars sold by European manufacturers in America, in dollars, will be effectively less expensive than they were before.
On the other hand, a more valuable currency make exports relatively more expensive for purchase in foreign markets. In other words, exporters become more competitive in a global market. Exports are encouraged while imports are discouraged. There should be some caution, however, for two reasons.
First, as the demand for a country's exported goods increases worldwide, the price will begin to rise, normalizing the initial effect of the devaluation. The second is that as other countries see this effect at work, they will be incentivized to devalue their own currencies in kind in a so-called "race to the bottom.
Exports will increase and imports will decrease due to exports becoming cheaper and imports more expensive. This favors an improved balance of payments as exports increase and imports decrease, shrinking trade deficits. Persistent deficits are not uncommon today, with the United States and many other nations running persistent imbalances year after year.
Economic theory, however, states that ongoing deficits are unsustainable in the long run and can lead to dangerous levels of debt which can cripple an economy. Devaluing the home currency can help correct balance of payments and reduce these deficits.
There is a potential downside to this rationale, however. Devaluation also increases the debt burden of foreign-denominated loans when priced in the home currency. This is a big problem for a developing country like India or Argentina which hold lots of dollar- and euro-denominated debt. These foreign debts become more difficult to service, reducing confidence among the people in their domestic currency.
A government may be incentivized to encourage a weak currency policy if it has a lot of government-issued sovereign debt to service on a regular basis. If debt payments are fixed , a weaker currency makes these payments effectively less expensive over time. Again, this tactic should be used with caution. As most countries around the globe have some debt outstanding in one form or another, a race to the bottom currency war could be initiated.
This tactic will also fail if the country in question holds a large number of foreign bonds since it will make those interest payments relatively more costly. The price of such policies is lower output and employment than would occur with a more expansionary but inflationary approach.
In contrast, if the aggregate supply of goods and services in the economy can be expanded, domestic price levels can be held down while output and employment grow. Thus, countries that enhance productivity growth through adoption of new technologies and economic reforms that reduce real costs of carrying out business can improve their international competitiveness and the purchasing power of the domestic currency without facing the social costs of reduced employment and output.
The role of the inflation rate in determining the real exchange rate has another implication. A devaluation of the nominal exchange rate, by raising the price of imported goods e. This reduces the impact of the nominal devaluation on the real exchange rate. Indeed, if not controlled, the resulting inflationary spiral can completely undo the real effects of the devaluation.
Thus, nominal devaluations are often accompanied by policy measures e. Why Devalue? A country typically devalues its currency raises its nominal exchange rate because the prevailing exchange rate is resulting in an unsustainable loss of foreign reserves. That is, the prevailing exchange rate makes imports appear very cheap to domestic consumers relative to comparable domestic products, leading to high levels of imports.
Similarly, exports and direct investment in the country appear expensive to potential foreign clients, thus reducing their attractiveness. The country with the overvalued currency therefore is spending more foreign exchange than it is earning, a process that cannot go on indefinitely. Overvaluation may result from the development strategy followed by a country.
From the 50s through the 70s, many developing countries followed an import-substitution-led industrialization strategy. Such strategies were based on the assumption that there was little scope for growth through traditional exports. The approach therefore emphasized trying to develop domestic industry behind high tariff walls for finished industrial products.
An overvalued exchange rate helped increase the profitability of these domestic industries by cheapening the price of imported intermediate inputs and wage goods, such as food, which held down labor costs. Most countries that followed this development strategy had much lower rates of growth than countries following a more outward-looking, export-oriented strategy Dornbusch This poor performance, combined with the debt crisis, brought about in part by overvalued exchange rates, led many countries to shift to more export-oriented strategies in the s and s.
Devaluation was typically one major element in the shift to these more outward-oriented strategies. Figure 1 illustrates overvaluation and devaluation. For simplicity, it depicts these relationships in nominal terms. A devaluation is an increase in the price of foreign exchange in terms of domestic currency, represented by a movement upward on the vertical axis in figure I.
The line segment S in figure 1 represents the supply schedule for foreign exchange, while D represents the demand schedule. The intersection of the supply and demand curves yields the equilibrium exchange rate e. At that exchange rate, there is no net change in foreign reserves; the country is taking in just as much foreign exchange as it is spending.
Figure 1: The determination of the equilibrium Exchangerate The supply schedule of foreign exchange shows how much foreign exchange people from outside the country are willing to supply for a given price of the currency.
The supply schedule represents 1 how much foreigners want the domestic currency in order-to buy goods and services from the country, 2 net private foreign investment flowing into the country from abroad, and 3 other capital inflows into the country, such as remittances from workers abroad and foreign aid. The lower the price level in the domestic economy relative to prices abroad, the more attractive the domestic country's exports are and the more appealing the country is for foreign investment that produces tradable goods.
Hence, the level of domestic inflation relative to inflation in trading partners is a prime determinant of the supply of foreign exchange. Similarly, the more stable the business climate, the more willing are foreign residents including nationals living abroad to invest in me country, leading to a lower exchange rate, ceteris paribus.
An increase in the supply of foreign exchange a shift outward in S results in a lower equilibrium exchange rate, that is, an appreciation of the domestic currency e.
The demand schedule for foreign exchange represents how intensely domestic residents of the country want foreign currency, either to buy foreign goods or to invest abroad. Macro-economic and political instability including high rates of domestic inflation often results in capital flight, as citizens try to protect their assets by shipping them out of the country.
An increase in demand for foreign exchange a shift out in D , leads to an increase in P e , that is, a depreciation in the exchange rate. The exchange rate can be set by government fiat at a rate other than the equilibrium rate. This excess demand can be dealt with in several ways: " The government can provide the needed additional foreign exchange by drawing down on its foreign exchange reserves.
For example, unless the government instituted other restrictions to limit access to foreign exchange, maintaining the exchange rate at PO would result in a loss of foreign exchange equal to Qd o - Qs o.
Such outflows can be sustained only as long as the reserves hold out or as long as foreign countries are willing to finance the debt as was the case with French support of the overvalued CFA Franc. Similarly, it can decrease the price of selected exports-by subsidizing them, thereby increasing the supply of foreign exchange, as these commodities now are cheaper to foreign buyers. In contrast, a "complete" devaluation applies to all goods and services in the economy.
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