Chapter 159 - The Rise of New Keynesian Economics

The Rise of New Keynesian Economics

The evolution of macroeconomic thought has been marked by pivotal shifts in theoretical frameworks, each responding to perceived inadequacies in prevailing models and emerging economic realities. Among the most significant developments in late twentieth-century economics was the rise of New Keynesian economics—a school of thought that sought to reconcile the Keynesian emphasis on market failures and the real effects of monetary policy with the methodological rigor of dynamic general equilibrium modeling pioneered by the New Classical economists. This intellectual movement, which emerged primarily during the 1980s and matured through the 1990s, has fundamentally reshaped both academic macroeconomics and the practice of monetary policy at central banks worldwide.

Historical Context and the Crisis of Keynesian Economics

To understand the rise of New Keynesian economics, one must first appreciate the turbulent intellectual landscape from which it emerged. The original Keynesian revolution, sparked by John Maynard Keynes's General Theory of Employment, Interest, and Money in 1936, had profoundly influenced macroeconomic thought and policy for decades. Keynes challenged classical economic theories by emphasizing the role of aggregate demand in determining output and employment, arguing that insufficient demand could lead to persistent involuntary unemployment. His framework provided intellectual justification for active government intervention through fiscal and monetary policies to stabilize economic fluctuations.^[1][2]

By the 1970s, however, the Keynesian consensus faced mounting challenges. The decade witnessed stagflation—the simultaneous occurrence of high inflation and high unemployment—a phenomenon that traditional Keynesian models struggled to explain. The Phillips curve, which had suggested a stable trade-off between inflation and unemployment, appeared to break down as both variables rose together. This crisis of explanation opened the door for a fundamental critique of Keynesian macroeconomics from an emerging school of thought known as New Classical economics.^[3][4]

The New Classical Challenge and the Lucas Critique

The New Classical revolution, led by economists such as Robert Lucas, Thomas Sargent, and Robert Barro, mounted a devastating intellectual assault on the theoretical foundations of Keynesian economics. At the heart of this critique was Lucas's 1976 paper, which introduced what became known as the "Lucas Critique". Lucas argued that the behavioral relationships estimated in traditional Keynesian macroeconometric models were not structural—that is, they would change when policymakers altered their policies. This insight fundamentally challenged the practice of using historical correlations to predict the effects of alternative policy regimes.^[5][6][4][7]

Lucas and his colleagues championed a methodological approach emphasizing rational expectations, explicit microfoundations derived from optimizing behavior by economic agents, and market-clearing assumptions. They developed models in which fluctuations in output and employment arose from optimal responses to shocks—particularly unexpected monetary policy changes—rather than from market failures or coordination problems. The New Classical models suggested that only unanticipated policy actions could have real effects, while anticipated policies would be neutral.^[4][8][5]

The Real Business Cycle (RBC) theory, developed in the early 1980s by economists including Edward Prescott, represented an even more radical departure from Keynesian thinking. RBC models attributed economic fluctuations primarily to real shocks—particularly technological innovations—rather than to monetary or demand-side disturbances. These models assumed perfectly flexible prices and wages, implying that observed business cycles reflected efficient responses to productivity changes rather than market failures requiring policy intervention.^{[9][10][11][12]}

By the early 1980s, the Keynesian view appeared to be in serious intellectual retreat. As one assessment noted, "there was a widespread impression that the best and brightest young macroeconomists almost uniformly marched under the new-classical banner". Yet reports of Keynesian economics's demise would prove premature.^[13]

The New Keynesian Response: Microfoundations for Price Rigidities

The economists who would become known as New Keynesians responded to the New Classical challenge not by rejecting it wholesale, but by accepting many of its methodological innovations while retaining the Keynesian emphasis on nominal rigidities and market imperfections. As Gregory Mankiw later reflected, "My temperament was always like, okay, not everything's right with these models, but there's some truth to the models too. And just throwing everything out and starting from scratch may seem like fun from the standpoint of intellectual revolution, but it seems a little too immersed".^[14][5][13]

The New Keynesian project, which began to coalesce in the late 1970s and flourished throughout the 1980s, aimed to provide rigorous microfoundations for the sluggish adjustment of wages and prices that Keynesian economists had long emphasized. The central insight was that even small costs or frictions in the price-setting process could generate substantial nominal rigidities with important macroeconomic consequences.^[15][5][13]

Staggered Price Setting and Wage Contracts

The first wave of New Keynesian theory emerged from models of staggered contracts developed in the late 1970s. Stanley Fischer's 1977 paper on long-term contracts under rational expectations represented a seminal contribution. Fischer developed a model in which wages were set in overlapping contracts, meaning that only a fraction of wages could be adjusted in any given period. John B. Taylor extended this framework in 1979 and 1980, developing models of staggered wage setting that showed how the presence of long-term contracts could generate persistent real effects from monetary policy, even under rational expectations.^[16][17]

These early models demonstrated a crucial point: nominal rigidities could coexist with rational expectations and optimizing behavior. Agents setting wages or prices rationally took into account that their decisions would remain in effect for multiple periods, during which other agents might adjust their own prices. This "staggered" structure meant that newly set prices depended on expectations of future prices, creating persistence in the effects of monetary shocks.^[18][16]

Guillermo Calvo's 1983 paper provided an analytically tractable framework for modeling sticky prices that would become enormously influential. In the Calvo model, firms face a constant probability of being able to adjust their price in any given period, with this opportunity arriving randomly rather than on a predetermined schedule. When firms do get to adjust, they set their price optimally, taking into account the expected future path of costs and demand. This formulation elegantly captured the idea of infrequent price adjustment while preserving analytical tractability.^[19][20][21]

Menu Costs and Near-Rational Behavior

A parallel strand of New Keynesian research emphasized the role of "menu costs"—small fixed costs of changing nominal prices. N. Gregory Mankiw's 1985 paper "Small Menu Costs and Large Business Cycles" demonstrated that even tiny costs of price adjustment could have substantial macroeconomic effects. The key insight drew on an envelope theorem argument: when prices are near their optimal level, the private cost to a firm of not adjusting is second-order (very small), but the social cost—in terms of aggregate output fluctuations—can be first-order (large).^{[22][23][24][15]}

This research connected to work by George Akerlof and Janet Yellen on "near-rational" behavior. They showed that small deviations from fully rational optimization could have large aggregate consequences when strategic complementarities were present. If each firm's optimal price depends positively on other firms' prices, then even a small tendency toward price stickiness by some firms would induce other firms to adjust their prices less aggressively, amplifying the aggregate effect.^[25][26]

Empirical research on menu costs yielded mixed results. Studies of actual price-setting behavior found that while firms did face costs of changing prices, the magnitude of pure menu costs appeared insufficient to explain the degree of price stickiness observed in the economy. This led researchers to explore other sources of nominal rigidity, including informational frictions, coordination problems, and implicit contracts.^[22]

Efficiency Wages and Labor Market Rigidities

New Keynesian economists also developed microfoundations for wage rigidities through efficiency wage theory. Building on earlier work by economists including Adam Smith, Alfred Marshall, and others, efficiency wage models posited that worker productivity depends positively on the wage paid. Firms might optimally pay wages above the market-clearing level to reduce turnover, elicit greater effort, attract higher-quality workers, or maintain worker morale.^[26][27][28]

George Akerlof and Janet Yellen made particularly important contributions to efficiency wage theory, exploring various mechanisms through which higher wages could enhance productivity. In models where workers compare their wages to reference standards—either within the firm or across the economy—firms that pay relatively high wages can elicit reciprocal effort from workers who value fairness. The equilibrium in such models features involuntary unemployment, as unemployed workers would willingly work at the prevailing wage but firms have no incentive to hire them at lower wages.^[27][26]

Lawrence Katz and others explored the empirical relevance of efficiency wage theories, finding support for several of the posited mechanisms. Efficiency wage considerations could help explain persistent unemployment, wage differentials across seemingly similar workers and jobs, and the cyclical behavior of real wages.^[28][26]

Coordination Failures and Strategic Complementarities

Russell Cooper and Andrew John's 1988 paper "Coordinating Coordination Failures in Keynesian Models" provided a game-theoretic framework for understanding how strategic complementarities in economic decisions could lead to coordination failures and multiple equilibria. When each agent's optimal action depends positively on the actions of other agents, the economy can become stuck in a low-activity equilibrium even when a high-activity equilibrium would be Pareto superior.^[29][30][31]

These coordination problems could arise from various sources: complementarities in production technologies, thick market externalities in matching processes, or demand spillovers in imperfectly competitive markets. The presence of strategic complementarities generated multiplier effects and could rationalize the effectiveness of aggregate demand policies. Moreover, coordination failures provided a theoretical basis for understanding how economies might experience large fluctuations in response to relatively small "sunspot" shocks that merely coordinated expectations.^[31][29]

The New Keynesian Synthesis: Building a Coherent Framework

By the early 1990s, New Keynesian economics had evolved from a collection of disparate models addressing specific rigidities into a more coherent framework. A landmark 1988 Brookings Paper by Laurence Ball, N. Gregory Mankiw, and David Romer synthesized many of the key insights. The authors demonstrated that New Keynesian models could explain a distinctive prediction: the relationship between inflation and the slope of the short-run Phillips curve. In their framework, higher average inflation leads to more frequent price adjustments, which in turn implies that nominal shocks have smaller real effects—a prediction they found support for in international data.^[32][33]

Gregory Mankiw and David Romer's 1991 two-volume collection New Keynesian Economics brought together seminal papers representing the new paradigm. The volumes covered sticky price adjustment, staggering of wages and prices, imperfect competition, coordination failures, and various market imperfections. These works established New Keynesian economics as a distinct research program with shared methodological commitments and substantive conclusions.^[34][35]

Key Figures and Intellectual Leadership

The development of New Keynesian economics involved contributions from numerous economists, with several playing particularly central roles. Olivier Blanchard's 1987 paper with Nobuhiro Kiyotaki on monopolistic competition and aggregate demand shocks provided important foundations for subsequent work. Their model showed how imperfect competition combined with nominal rigidities could generate Keynesian outcomes from microeconomic optimization.^[36][37][38]

Michael Woodford emerged as another towering figure in the New Keynesian tradition. His work in the late 1990s and early 2000s, culminating in his influential 2003 book Interest and Prices, provided a comprehensive theoretical framework for understanding optimal monetary policy in New Keynesian models. Woodford demonstrated how interest rate rules could be used to implement optimal policy and analyzed the conditions under which such rules would lead to determinate, stable equilibria.^[39][37][36]

Jordi Galí made crucial contributions to synthesizing and extending the New Keynesian framework. His textbook Monetary Policy, Inflation, and the Business Cycle became a standard reference, providing a clear exposition of the canonical New Keynesian model and its policy implications. Galí also conducted important empirical work testing the predictions of New Keynesian models and exploring extensions including labor market frictions and financial imperfections.^{[40][37][41][42][36]}

These three economists—Blanchard, Woodford, and Galí—were collectively awarded the 2025 BBVA Foundation Frontiers of Knowledge Award for their foundational work establishing New Keynesian economics as the dominant paradigm in modern macroeconomics.^[37][43][36]

The New Keynesian Model: Core Structure and Dynamics

By the late 1990s, a canonical New Keynesian model had emerged as the workhorse framework for monetary policy analysis. This model combined the dynamic stochastic general equilibrium (DSGE) structure of Real Business Cycle theory with key Keynesian elements: monopolistic competition, nominal price rigidities, and the implied non-neutrality of monetary policy.^[44][9][40]

The Three-Equation Framework

In its simplest form, the baseline New Keynesian model can be expressed as three key equations. First, a New Keynesian Phillips Curve relates current inflation to expected future inflation and a measure of real economic activity (typically a gap between actual and potential output):^[45][46][40]

π_t = βE_t[π_{t+1}] + κy_t

where π denotes inflation, y represents the output gap, β is a discount factor, and κ captures the sensitivity of inflation to real activity. This forward-looking Phillips curve differs fundamentally from traditional backward-looking specifications, as current inflation depends on expectations of future economic conditions rather than lagged inflation.^[47][45][40]

Second, a dynamic IS curve (or Euler equation) describes aggregate demand as depending on the real interest rate and expected future output:

y_t = E_t[y_{t+1}] - σ(i_t - E_t[π_{t+1}])

where i denotes the nominal interest rate and σ represents the intertemporal elasticity of substitution. This equation captures how higher real interest rates reduce current demand relative to expected future demand.^[45][40]

Third, a monetary policy rule describes how the central bank sets the nominal interest rate in response to inflation and output:

i_t = r* + π_t + φ_π(π_t - π*) + φ_y y_t

where r* is the natural rate of interest, π* is the inflation target, and φ_π and φ_y are policy response coefficients. This formulation captured the essential features of the Taylor rule proposed by John Taylor in 1993.^{[48][49][50][51]}

The Taylor Rule and Monetary Policy

John Taylor's 1993 paper "Discretion versus Policy Rules in Practice" proved enormously influential in shaping both New Keynesian theory and actual central bank practice. Taylor showed that a simple rule relating the federal funds rate to inflation and the output gap described Federal Reserve behavior remarkably well over the previous several years. The rule prescribed that the central bank should raise interest rates more than one-for-one with increases in inflation—a principle that came to be known as the "Taylor principle".^{[49][50][51][48]}

The Taylor principle proved crucial for ensuring determinacy of equilibrium in New Keynesian models. If the central bank responds to higher inflation by raising the nominal rate less than one-for-one, the real interest rate falls, stimulating demand and generating even higher inflation—a potentially explosive spiral. Conversely, responding more aggressively ensures that deviations from the inflation target are self-correcting. This insight provided theoretical foundation for inflation-targeting frameworks that many central banks adopted in the 1990s and 2000s.^{[52][53][54][39][45]}

Policy Implications and Central Bank Practice

New Keynesian economics generated clear policy implications that proved highly influential in actual monetary policy practice. Perhaps most fundamentally, the framework provided intellectual justification for active monetary policy aimed at stabilizing both inflation and output fluctuations. In contrast to Real Business Cycle theory, which suggested that observed fluctuations reflected efficient responses to productivity shocks, New Keynesian models implied that monetary policy could improve welfare by offsetting demand disturbances and reducing volatility.^[55][56][54]

Inflation Targeting and Policy Transparency

The New Keynesian framework supported the movement toward explicit inflation targeting that swept through central banks in the 1990s and 2000s. New Zealand pioneered formal inflation targeting in 1990, followed by Canada, the United Kingdom, and eventually dozens of other countries. While the Federal Reserve never adopted an explicit inflation target during this period, its policy behavior increasingly resembled that of inflation targeters.^{[53][54][51][52]}

The framework also emphasized the importance of policy transparency and clear communication about the central bank's objectives and reaction function. By anchoring inflation expectations at the target level, transparent policy could reduce the volatility of both inflation and output. Forward-looking models implied that expectations about future policy mattered as much as current policy actions, making communication a potentially powerful policy tool.^{[51][57][52][45]}

The Zero Lower Bound and Unconventional Policy

The global financial crisis of 2007-2009 and the subsequent prolonged period of near-zero interest rates tested New Keynesian models in unprecedented ways. When short-term nominal interest rates approached zero—the "zero lower bound" (ZLB)—central banks could no longer provide additional stimulus through conventional interest rate cuts. This situation had been largely theoretical before the crisis but became a practical reality affecting major economies.^[57][52][44]

New Keynesian theory suggested two main approaches to providing stimulus at the ZLB. Forward guidance—explicit communication about how long the central bank intended to keep rates low—could lower long-term interest rates by shaping expectations about future short-term rates. If the central bank credibly committed to keeping rates low longer than normal policy rules would suggest, it could stimulate current demand by raising expectations of future inflation and activity.^[58][59][57]

Quantitative easing (QE)—large-scale purchases of longer-term securities—represented another unconventional tool. While the standard New Keynesian model implied that the size and composition of the central bank's balance sheet should be irrelevant (a result known as the Wallace neutrality), extensions incorporating financial frictions and market segmentation suggested that asset purchases could lower long-term rates and stimulate the economy.^[60][57][58]

Central banks, including the Federal Reserve, European Central Bank, Bank of England, and Bank of Japan, deployed both forward guidance and quantitative easing extensively during and after the financial crisis. Research by Ben Bernanke and others suggested these policies proved "highly effective" at lowering long-term interest rates, though "a great deal of uncertainty" remained about their precise effects on the real economy.^{[61][57][58][60]}

Extensions, Refinements, and Ongoing Debates

As New Keynesian economics matured through the 2000s and 2010s, researchers worked to address limitations and extend the framework in various directions. The global financial crisis highlighted the absence of financial frictions from baseline New Keynesian models—an omission that proved consequential given the financial origins of the Great Recession.^[62][41][44]

Financial Frictions and the Financial Accelerator

Work by Ben Bernanke, Mark Gertler, Simon Gilchrist, and others incorporated financial frictions into New Keynesian models through the "financial accelerator" mechanism. In these models, credit market imperfections—arising from asymmetric information between borrowers and lenders—amplify the effects of shocks on economic activity. A deterioration in borrower balance sheets increases external finance premiums, reducing investment and consumption and thereby magnifying the initial shock.^[63][62]

The financial accelerator mechanism helped explain several features of the Great Recession, including the severity and persistence of the downturn following the financial panic of 2008. Models incorporating financial frictions suggested that unconventional policies targeting credit markets—not just short-term interest rates—could be particularly effective during financial crises.^[62][63]

Heterogeneity and Inequality

The representative agent framework underlying most New Keynesian models came under increasing scrutiny, particularly regarding the distributional consequences of monetary policy and fiscal interventions. Traditional models assumed that all households were identical, or that differences across households could be safely ignored for analyzing aggregate dynamics. However, research on household heterogeneity suggested this abstraction might miss important features of policy transmission.^[41][44]

Models with heterogeneous agents and incomplete markets—often labeled "HANK" (Heterogeneous Agent New Keynesian) models—revealed that the distributional effects of policy could significantly affect aggregate dynamics. For instance, the marginal propensity to consume differed substantially across households depending on their wealth and access to credit, implying that policies affecting the distribution of income and wealth could have important macroeconomic effects.^[44][41]

Labor Market Dynamics and Unemployment

Baseline New Keynesian models typically lacked an explicit treatment of unemployment, representing the labor market through a labor supply elasticity in the representative household problem. This omission seemed particularly glaring given that unemployment is a central concern of macroeconomic policy. Olivier Blanchard, Jordi Galí, and others developed extensions incorporating search and matching frictions in labor markets, providing an explicit model of unemployment determination.^[64][65]

These labor market models showed how various shocks—including monetary policy actions—affect unemployment through their effects on job creation and destruction. The framework helped rationalize the sluggish adjustment of employment following the Great Recession and informed debates about labor market policies.^[65][64]

Criticisms and Alternative Perspectives

Despite its dominance in academic macroeconomics and central bank practice, New Keynesian economics has faced sustained criticism from various quarters. Some critiques focus on specific modeling choices or empirical predictions, while others challenge the entire framework more fundamentally.^[66][67][44]

Empirical Challenges

New Keynesian models were widely criticized for failing to predict the global financial crisis of 2007-2009—an accusation leveled against modern macroeconomics more broadly. Critics argued that the absence of financial frictions from standard models meant they could not account for the key factors behind the crisis. While subsequent extensions incorporated financial sectors, skeptics questioned whether models that required substantial modification after the fact could provide reliable guidance.^[67][44]

The behavior of inflation during the Great Recession also challenged New Keynesian predictions. Standard models predicted that the massive output gap following the 2008-2009 recession should have generated substantial deflation, yet inflation remained relatively stable at low positive levels—a phenomenon some called the "missing disinflation" puzzle. Various explanations were proposed, including downward nominal wage rigidities, anchored inflation expectations, and mismeasurement of economic slack, but debates continued.^[68][63][62]

Methodological Concerns

Post-Keynesian and other heterodox economists rejected the New Keynesian framework on more fundamental grounds. They argued that the representative agent assumption, rational expectations hypothesis, and equilibrium methodology failed to capture essential features of Keynes's original insights about fundamental uncertainty, effective demand failures, and inherent instability in capitalist economies.^{[69][70][71][66]}

Post-Keynesians emphasized endogenous money creation by the banking system, the role of historical time and irreversibility, and systemic instability driven by financial speculation and debt dynamics. They contended that New Keynesian models' assumption of a stable equilibrium to which the economy naturally tends missed the possibility of persistent stagnation or instability. Moreover, post-Keynesians argued that the New Keynesian focus on nominal rigidities as the source of Keynesian results fundamentally misinterpreted Keynes's theory.^{[72][71][73][66][69]}

Some mainstream economists also raised methodological concerns. John Cochrane questioned whether New Keynesian models at the zero lower bound generated sensible predictions, noting that they seemed to imply paradoxical results such as negative supply shocks being expansionary. Others worried about the "Lucas critique" applying to New Keynesian models themselves—that the structural parameters estimated in these models might change when policies changed.^{[7][8][74][75][76][77][44]}

Real Business Cycle Alternatives

Advocates of Real Business Cycle theory continued to argue that most macroeconomic fluctuations reflected efficient responses to real shocks rather than demand-driven market failures requiring policy intervention. RBC theorists emphasized that New Keynesian models required implausibly large nominal rigidities to explain observed output volatility and that the micro evidence on price and wage stickiness remained contested.^[10][11][12]

Gregory Mankiw, in a 1989 appraisal from a "New Keynesian Perspective," acknowledged Real Business Cycle theory's intellectual appeal through its unified treatment of growth and fluctuations using Walrasian principles. However, he argued that RBC theory's reliance on large technology shocks and high intertemporal substitution of leisure to explain employment fluctuations lacked empirical support. The two approaches reflected different weights given to "internal consistency" (extending a unified theoretical framework) versus "external consistency" (matching observed patterns in the data).^[12]

The Contemporary State of New Keynesian Economics

As of the mid-2020s, New Keynesian economics remains the dominant paradigm in academic macroeconomics, graduate education, and monetary policy institutions worldwide. Central banks throughout the developed and developing world employ medium-scale DSGE models built on New Keynesian foundations for forecasting and policy analysis. The framework provides a common language for policy debates and a benchmark against which alternative proposals are evaluated.^{[9][36][40][41][44]}

Yet the paradigm continues to evolve in response to both empirical challenges and theoretical advances. Active areas of research include incorporating more realistic financial sectors, modeling heterogeneity more carefully, understanding secular stagnation and persistently low interest rates, analyzing the distributional consequences of monetary and fiscal policies, and grappling with the implications of occasionally binding constraints like the zero lower bound.^[76][41][44]

The COVID-19 pandemic and associated policy responses created new challenges and opportunities for New Keynesian analysis. The unprecedented fiscal interventions, the role of supply-side disruptions in generating inflation, and the rapid policy tightening by central banks in 2022-2023 all tested New Keynesian frameworks in novel ways. Debates continue about how well the models explain recent inflation dynamics and what they imply for optimal policy going forward.^[78]

Conclusion: An Enduring but Evolving Paradigm

The rise of New Keynesian economics represents one of the most significant intellectual developments in twentieth-century economics. Emerging from the theoretical and policy crises of the 1970s and 1980s, New Keynesian economists successfully integrated rigorous microfoundations and rational expectations—the methodological innovations of the New Classical revolution—with the Keynesian emphasis on nominal rigidities, market imperfections, and the potential for welfare-improving policy interventions.^[5][13][44]

The framework's influence extends far beyond academia. Central banks worldwide have adopted policy frameworks—particularly inflation targeting and Taylor-rule-like interest rate policies—that draw heavily on New Keynesian insights. The theory shaped responses to the global financial crisis and subsequent economic challenges, informing the use of unconventional monetary policies and justifying unprecedented fiscal interventions.^{[54][52][51][57][58][61]}

Nevertheless, New Keynesian economics faces ongoing challenges and criticism. Empirical anomalies, including the missing disinflation puzzle and debates about inflation dynamics, continue to generate research and revision. Heterodox critics argue that the framework's equilibrium methodology and representative agent assumptions miss essential features of Keynesian economics properly understood. Even within mainstream economics, debates persist about the sources of nominal rigidities, the role of heterogeneity and financial frictions, and the proper scope and limits of monetary policy.^{[73][66][67][63][41][69][44][62]}

What seems certain is that New Keynesian economics will continue to evolve. The paradigm has proven remarkably flexible, incorporating financial frictions, heterogeneous agents, and various other extensions in response to empirical and theoretical challenges. Whether these modifications represent genuine progress or symptom of an increasingly unwieldy framework remains contested. Yet given its institutional entrenchment, intellectual momentum, and lack of a clearly superior alternative, New Keynesian economics seems likely to remain the dominant framework for macroeconomic analysis and policy for the foreseeable future.^{[79][41][76][44]}

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Chapter 159 - The Rise of New Keynesian Economics

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