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R. GLENN
HUBBARD
ANTHONY PATRICK
O’BRIEN
FIFTH EDITION
© 2015 Pearson Education, Inc..
CHAPTER
CHAPTER
8
GDP: Measuring Total
Production and Income
Chapter Outline and
Learning Objectives
8.1
Gross Domestic Product
Measures Total Production
8.2
Does GDP Measure What
We Want it to Measure?
8.3
Real GDP versus Nominal
GDP
8.4
Other Measures of Total
Production and Total
Income
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Microeconomics and Macroeconomics
Microeconomics is the study of how households and firms make
choices, how they interact in markets, and how the government
attempts to influence their choices.
In contrast, macroeconomics is the study of the economy as a
whole, including topics such as inflation, unemployment, and
economic growth.
• When we want to study the overall economy-level actions of
people and governments, the models and tools of
macroeconomics become very useful.
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Some Important Terms in Macroeconomics
Business cycle: Alternating periods of economic expansion and
economic recession.
Expansion: The period of a business cycle during which the total
production and total employment are increasing.
Recession: The period of a business cycle during which total
production and total employment are decreasing.
Economic growth: The ability of an economy to produce increasing
quantities of goods and services.
Inflation rate: The percentage increase in the price level from one
year to the next.
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Goal of This Chapter
Over the coming chapters, we will explore many aspects of the
economy, including how all of the elements on the previous slide
relate to one another.
For this chapter, we have a less lofty goal: to figure out how to
measure the total output of an economy.
Being able to measure total output is incredibly important, since
much of macroeconomics depends on our ability to measure and
predict aggregate economic activity.
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The study of how a business firm establishes the price
and quantity to be produced and how to maximize profit
is:
a. A macroeconomic study.
b. A microeconomic study.
c. A study of inflation.
d. A study pertaining to the business cycle.
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Gross Domestic Product Measures Total Production
8.1 LEARNING OBJECTIVE
Explain how total production is measured.
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Measuring Total Production: Gross Domestic Product
The most common measure used by economists of overall economic
activity in an economy is Gross domestic product, or GDP.
Gross domestic product: the market value of all final goods and
services produced in a country during a period of time, typically one
year.
We will examine each of the parts of this definition in turn.
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“Market Values”
Gross domestic product: the market value of all final goods and
services produced in a country during a period of time, typically one
year.
We cannot add together the number of cars, melons, haircuts, and all
other goods and services without agreeing on a common way to
measure them.
The best practical way is to value each good and service in monetary
terms; and the best measure of this that we have is the price that
each good or service is sold for.
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“Final Goods and Services”
Gross domestic product: the market value of all final goods and
services produced in a country during a period of time, typically one
year.
A final good or service is a good or service purchased by a final
user. These are what are used to calculate GDP.
• Why? If we counted intermediate goods and services as well,
ones that were inputs into another good or service, such as a tire
on a truck, then we would end up double-counting.
Example: if we counted the value of the ice cream bought by a store,
and also counted the value of that ice cream when it was sold to a
consumer, we would be double-counting the wholesale value of the
ice cream.
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“During a Period of Time”
Gross domestic product: the market value of all final goods and
services produced in a country during a period of time, typically one
year.
To measure total output in a given year, we measure the goods and
services produced only in that given year.
• Again, this avoids double-counting: if you buy a DVD in 2011, that
DVD counts in 2011’s GDP. If you resell it in 2012, it will not count
again in 2012.
• So GDP counts only new goods and services. Used items were
previously produced and counted, so don’t need to be counted
again.
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Production and Income
There are two main conceptual ways to measure the total economic
activity in an economy: total production or total income.
When we measure one, we are also measuring the other.
• Why? Everything that is produced and sold constitutes income for
someone; so we have the choice of measuring the value of
products produced and sold, or the value of incomes, and each is
a valid way of measuring economic activity.
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The Circular Flow and the Measurement of GDP
In a very simple model of the
economy, we could start with
households and firms.
To measure overall
economic activity, we could
measure the amount of
money that households
spend on goods and
services.
Or we could measure
income to households.
Figure 8.1
The circular flow and the
measurement of GDP
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Adding Government to the Circular Flow
Let’s add in some more
layers. We’ll start with
government.
How does the government
affect economic activity?
• It takes in taxes from
households and firms.
• It uses those taxes to
buy goods and services,
and to make transfer
payments—payments
to households for which
the government does not
Figure 8.1
receive a good or
The circular flow and the
service in return.
measurement of GDP
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Adding the Rest of the World to the Circular Flow
Some economic activity
takes place between
households, firms, and the
rest of the world.
• Households buy goods
and services from firms
in other countries; these
are known as imports.
• Firms sell goods and
services to households
in other countries; these
are known as exports.
Figure 8.1
The circular flow and the
measurement of GDP
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Adding the Financial System to the Circular Flow
Finally, there are firms that
deal specifically in flows of
money; we label these
firms the financial system.
• Households elect not to
spend some of their
income, and instead
save it with financial
system firms like banks.
• These financial system
firms lend money to
other firms and the
government.
Figure 8.1
The circular flow and the
measurement of GDP
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Follow the Spending to Measure GDP
To measure GDP, the Bureau of Economic Analysis (BEA) in the
Department of Commerce measures four major categories of
expenditures:
• Personal Consumption Expenditures, or “Consumption” (C)
• Gross Private Domestic Investment, or “Investment” (I)
• Government Consumption and Gross Investment, or “Government
Purchases” (G)
• Net Exports of Goods and Services, or “Net Exports” (NX)
GDP can be expressed as the sum of these:
Y = C + I + G + NX
We will examine each component of GDP in turn.
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Consumption
Y = C + I + G + NX
Consumption is spending by households on goods and services, not
including spending on new houses (which are counted instead in
investment).
In BEA statistics, consumption is further divided into expenditure on
services, durable goods, and nondurable goods.
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Investment
Y = C + I + G + NX
Investment is spending by firms on new factories, office buildings,
and additions to inventories, plus spending by households and firms
on new houses.
The BEA measures the following categories of investment: business
fixed investment, residential investment, and changes in business
inventories.
• This last category includes goods that have been produced but not
yet sold.
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Government Purchases
Y = C + I + G + NX
Government purchases are spending by federal, state, and local
governments on goods and services, such as teachers’ salaries,
highways, and aircraft carriers.
This does not include transfer payments, since those do not result in
immediate production of new goods and services.
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Net Exports
Y = C + I + G + NX
Net exports are defined as the value of exports minus the value of
imports. This difference might be positive or negative; in recent years,
this has been negative in the United States.
Since we want to count domestic production (production in the United
States), we add up the value of the goods and services sold to
foreigners, and subtract off the value of the goods and services sold
to Americans by foreigners.
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Components of GDP in 2012
Figure 8.2
Components of GDP in 2012
Consumption is the largest component of GDP; within that,
services are the largest component—almost half of GDP.
American net exports are negative, since the value of our imports
exceeds the value of our exports.
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Making
the
Connection
Adding More of Lady Gaga to GDP
The BEA continually studies ways to
improve its measurement of GDP.
In 2013, the BEA started counting R&D
as investment, rather than an
intermediate good, so as to emphasize
the importance of intellectual property.
• A consequence is that money spent
on development of, say,
entertainment products, now gets
counted as investment.
• So the money spent by Lady Gaga
and her record company on writing
and recording her songs is now
included in the investment
component of GDP.
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Measuring GDP Using the Value-Added method
An alternative method to measure GDP is to measure the value
added: the market value a firm adds to a product.
The final selling price of a product must equal the sum of the values
added to the product at each stage of production.
The table below illustrates this method for a shirt sold on L.L.Bean’s
web site.
Firm
Value of Product
Value Added
Cotton farmer
Value of raw cotton = $1
Value added by cotton farmer
=
1
Textile mill
Value of raw cotton woven
into cotton fabric = $3
Value added by cotton textile
mill = ($3 − $1)
=
2
Shirt company
Value of cotton fabric made
into a shirt = $15
Value added by shirt
manufacturer = ($15 − $3)
=
12
L.L.Bean
Value of shirt for sale on
L.L.Bean’s Web site = $35
Value added by L.L.Bean
= ($35 − $15)
=
20
Total Value Added
= $35
Table 8.1
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Calculating value added
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How is GDP measured?
a. GDP is measured by adding the quantities of goods
and services produced in a given year.
b. GDP is measured using market values.
c. GDP is measured using stock market values, or
stock prices.
d. GDP is measured by adding the prices of goods and
services throughout the economy.
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Which of the following is counted in this year’s value of
GDP?
a. The value of this year’s production added to the
value of production in previous years.
b. The value of new production added to the value of
the goods resold this year.
c. Only the value of this year’s production of goods and
services.
d. The value of this year’s production added to the
value of goods and services produced last year.
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How is GDP calculated?
a. By adding the prices of the goods and services in
question.
b. By adding the quantities of goods and services in
question.
c. By multiplying the price times the quantity of each
good and service sold in the current period, then
adding the results.
d. By dividing the quantities of goods and services by
the prices paid.
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Which of the following is not included in national
income?
a.
b.
c.
d.
Rent.
Interest.
Profits.
Transfer payments, including Social Security
payments.
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Which of the following is included in the economist’s
definition of investment?
a. The purchase of a machine, factory, or house.
b. The purchase of a share of stock.
c. The purchase of a rare coin or deposit in a savings
account.
d. All of the above.
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In the equation that sums up the information on the
components of GDP, Y = C + I + G + NX, which
component is the largest?
a. C.
b. I.
c. G.
d. NX.
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In GDP accounting, which levels of government
spending are included in government spending?
a. Spending by the federal government only.
b. Spending by federal, state, and local governments.
c. Spending by the federal government and some state
governments, but not local governments.
d. Spending by governments only as they relate to
national security, social welfare, and other national
programs.
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The difference between the price the firm sells a good
for and the price it paid other firms for intermediate
goods is called:
a. Producer surplus.
b. Fixed investment.
c. Value added.
d. Profit.
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Does GDP Measure What We Want It to Measure?
8.2 LEARNING OBJECTIVE
Discuss whether GDP is a good measure of well-being.
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Shortcomings of GDP
GDP can be a useful tool to measure total output in an economy.
Many people go further than this, interpreting GDP as a measure of
the well-being of citizens.
However GDP has shortcomings, both in its measure of total
production, and in its usefulness as a measure of well-being.
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Shortcomings of GDP as a Measure of Total Production
Two important types of production are omitted from the BEA’s
measurement of GDP:
Household Production
• Household production such as childcare, cleaning, and cooking is
not typically paid for with money. However such contributions are
real—if they were performed by a non-household-member, they
would be paid for and counted in GDP.
The Underground Economy
• Buying and selling of goods and services might be concealed from
the government to avoid taxes or regulations, or because the
goods and services are illegal. This constitutes the underground
economy.
• This may be 10% or more of the economy in America, and
substantially more in low-income households.
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How Important Are These Shortcomings?
If we are comparing GDP from year to year, the size of household
production and the underground economy is probably about the same
from year to year, so GDP growth is a reasonable measure of the
growth in total production.
However over long periods of time, these shortcomings might be
more serious.
Example: As women have entered the workforce in larger numbers,
some household production has been replaced by paid childcare and
restaurant meals. So increases in GDP may exaggerate the increase
in actual total production.
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Making Underground Economies in Developing Countries
the
Connection
In developing countries, the
underground economy is often
referred to as the informal sector, as
opposed to the formal sector, in
which output of goods and services
is measured.
• In many developing countries, the
informal sector is very large;
often above 50% of total output.
Economists studying economic
development say this often reflects
poor government policies: high
taxes and regulations and low
confidence in the security of private
property from government seizure.
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Shortcomings of GDP as a Measure of Well-Being
GDP per capita (i.e. GDP divided by population) is often used to
represent differences in standards of living from country to country.
However, even if it accurately measured total production, it would not
reflect:
• The value of leisure
• Pollution and other negative effects of production
• Crime and other social problems
• The distribution of income
In fact, improvements in many of these will result in lower GDP per
capita.
Example: Lower crime would allow lower spending on police, prisons,
and private security. This would decrease GDP, but surely result in
improvements in economic well-being.
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Making
the
Connection
Did World War II Bring Prosperity?
World War II was a
period of extraordinary
sacrifice and
achievement by the
“greatest generation.”
But statistics on GDP
may give a misleading
indication of whether it
was also a period of
prosperity:
• Production was very high, but much of the production was of
military goods—so people weren’t becoming more well-off.
• After the war, GDP fell; but the production of consumption goods
rose rapidly.
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Household production and the underground economy:
a. Are fully accounted for in GDP figures gathered by
the Commerce Department.
b. Are not considered formal production of goods and
services; therefore, are not included in GDP
accounting.
c. Are important but unaccounted for in the Commerce
Department’s estimate of GDP.
d. Is irrelevant because it constitutes only a very small
fraction of GDP for most countries.
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As the value of a country’s GDP increases, the country
is likely to:
a.
b.
c.
d.
Devote more resources to pollution reduction.
Devote fewer resources to pollution reduction.
Include the value of pollution in GDP accounting.
Exclude the value of pollution in GDP accounting.
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Real GDP versus Nominal GDP
8.3 LEARNING OBJECTIVE
Discuss the difference between real GDP and nominal GDP.
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Calculating Real GDP
Since GDP is measured in “value” terms, we might have problems
interpreting changes over time if prices change. Is an increase in
GDP due to production increasing, or due to prices increasing?
• To separate these effects, the BEA calculates both nominal
GDP—the value of final goods and services evaluated at currentyear prices—and real GDP—the value of final goods and services
evaluated at base-year prices.
The choice of a base-year is arbitrary; we might use any year’s prices
to compare real GDP in each year. The current standard is 2009.
• Unfortunately, the relative prices also change from year to year,
distorting real GDP calculations. Since 1996, the BEA has
overcome this problem by using chain-weighted prices, using
previous-year prices to adjust current-year production measure.
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Calculating Real GDP: An Example
2009
The table shows output and
prices in 2009 and 2015.
Calculating the total value of
output in 2009 gives:
Product
Quantity
Price
Quantity
Price
Eye
examinations
80
$40
100
$50
Pizzas
90
11
80
10
Textbooks
15
90
20
100
$3200 + $990 + $1350 = $5540.
To calculate real GDP in 2015,
we use the prices from 2009.
• This gives real 2015 GDP in
2009 dollars of $6680.
2015
Product
2015
Quantity
2009
Price
Value
Eye examinations
100
$40
$4,000
Pizzas
80
11
880
Textbooks
20
90
1,800
Most prices increased from 2009 to 2015, so using nominal GDP
would have yielded a higher figure: $7800.
• This highlights the need to use real GDP to avoid exaggerating
growth.
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Comparing Real GDP and Nominal GDP
The current base year
for calculating prices is
2009, so real and
nominal GDP are equal
in 2009.
Growth figures reported
in the media are the
growth in real GDP.
Since prices have
generally increased
since 2009, real GDP is
less than nominal GDP,
and the opposite is true
before 2009.
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Figure 8.3
Nominal GDP and real
GDP: 1990-2012
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The GDP Deflator
Economists and policy-makers are interested in the price level: a
measure of the average prices of goods and services in the economy.
• Why? Stable prices are desirable because they allow households
and firms to plan for the future appropriately.
In order to know whether we are achieving price stability, we need to
measure the price level.
• One way to do this is using the GDP deflator: a measure of the
price level, calculated by dividing nominal GDP by real GDP and
multiplying by 100:
GDP deflator 
Nominal GDP
100
Real GDP
Since nominal and real GDP will be the same in the base year, the
GDP deflator will be 100 in the base year.
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Calculating the GDP Deflator
The table on the right gives the
values of nominal and real
GDP for 2011 and 2012.
We can use this to calculate
the GDP deflator in each year:
Formula
2011
2012
Nominal GDP $15,534 billion $16,245 billion
Real GDP
Applied to 2011
$15,052 billion $15,471 billion
Applied to 2012
 $15,534 billion 
 $16,245 billion 
Nominal GDP
GDP
100  103 


100 
 100  105
Deflator
Real GDP
$15,052
billion
$15,471
billion




The GDP deflator increased from 103 to 105 between the two
years. This is a 1.9% increase:
 105  103 

 100  1.9%
 103 
So we say the price level rose 1.9% over this period.
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Which measure of GDP represents changes strictly in
the quantity of goods and services produced in the
economy, not the prices?
a. Nominal GDP.
b. Real GDP.
c. The GDP measure that sums up the value of goods
and services evaluated at current year prices.
d. None of the above. All GDP measures represent
changes in both prices and quantities.
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Growth in the economy is almost always measured as:
a.
b.
c.
d.
Growth in nominal GDP.
Growth in real GDP.
Growth in measured GDP.
The growth of personal disposable income.
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Which of the following is a measure of the aggregate
price level?
a.
b.
c.
d.
Inflation.
The GDP deflator.
Real GDP.
Nominal GDP.
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Other Measures of Total Production and Total Income
8.4 LEARNING OBJECTIVE
Understand other measures of total production and total income.
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National Income and Product Accounts (NIPA)
The BEA is charged with performing national income accounting for
the United States. Each quarter, it publishes the National Income
and Product Accounts tables.
These include GDP computations, but also:
Gross National Production performed by citizens of a nation,
Product (GNP) including overseas production (as opposed to GDP,
which is performed within national borders)
National
Income
GDP minus the consumption of fixed capital; i.e.
GDP minus depreciation
Personal
Income
Income received by households; includes transfer
payments, but excludes firms’ retained earnings
Disposable
Personal
Income
Personal income minus personal tax payments; this
measures the amount that households are able to
spend or save
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NIPA Measurements
The table and graph show the various measures of the national
income accounts for the United States in 2012.
• National income must be smaller than GDP, since it is just GDP
minus depreciation.
Similarly, disposable personal
income must be less than
personal income, since it is just
personal income minus taxes.
• Each measure is useful in
different contexts.
Figure 8.4
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Measures of total production
and total income, 2012
53
Total Production = Total Income
All production must be rewarded with income; so in theory, we could
count either in order to calculate GDP.
• In practice, data limitations make us unlikely to come up with the
same number; there will always be some statistical discrepancy.
The figure illustrates the division of income as measured by the BEA
in 2012.
Figure 8.5
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The division of income,
2012
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Common Misconceptions to Avoid
“Investment” in reference to national income accounting has a very
narrow definition: purchases of things like machines, factories, and
houses. It refers only to the purchase of new items, not trades in
financial instruments based on those items.
We based statements about growth on GDP; but GDP has limitations,
both as a measure of total production, and as a measure of wellbeing.
In order to make useful comparisons, concentrate on real GDP rather
than nominal GDP.
In calculating real GDP, the choice of base year is largely arbitrary;
there is no “correct” base year.
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When a significant fraction of domestic production takes
place in foreign-owned facilities, a country’s difference
between GDP and GNP is as follows:
a. GNP will be a more accurate measure of the level of
production within the country’s borders.
b. GDP will be much larger than GNP.
c. GNP will be almost identical to GDP.
d. GNP will be closer to zero.
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The best measure of the income households actually
have available to spend is:
a.
b.
c.
d.
National income.
Disposable personal income.
Net national product.
Gross Domestic Product.
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Which of these components of income is the largest?
a.
b.
c.
d.
Wages.
Rent.
Interest.
Profit.
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