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Fourie FCvN & Burger P (2019) How to think and reason in Macroeconomics - a
South African text. 5th edition. Cover, Preface & Table of Contents

Book · January 2020

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Preface

How to think and reason in macroeconomics – a South African text. Why the
complicated title?
First, this textbook purposefully and methodically teaches the reader how to think and
reason about economic behaviour, real-life processes and change in macroeconomics –
not merely how to manipulate a set of theoretical equations or shift a few curves around.
(After all, the economy does not have curves.)
Secondly, the text continually situates the analysis and comprehension of economic
processes in the South African context. Thus the reader will learn extensively about:
❐ relevant data and data sources to underpin understanding;
❐ economic institutions that shape economic processes, including policy institutions and
the political-economic landscape;
❐ policies that could be used (but also misused) in the pursuit of macroeconomic objectives
such as high employment, low inflation and steady growth; as well as
❐ broader considerations such as human development and inclusive growth – with South
Africa being an (upper-) middle-income country relative to peer countries in Africa and
elsewhere, as well as high-income countries.
But what does this really entail?

Combining intuitive understanding and sophisticated analysis


Modern macroeconomics, especially in advanced and postgraduate courses, typically
aims to equip students with the ability to manipulate complex mathematical models of the
economy. Yet one finds graduates with a first or advanced degree in economics who still do
not have the ability to analyse and converse about the basic operation and dynamics of the
economy, for example in response to cyclical or policy effects, or international economic
shocks. Economics graduates often have very limited knowledge of the institutions,
processes and data – and often feel they have to ‘unlearn’ or disregard prior ‘academic’
studies when they start work as practising economists in the private or public sectors.
Our point of departure is that theoretical insights and refinements should always be
rooted in a thorough intuitive understanding of economic behaviour, processes, data and
institutions. Without a solid intuitive understanding, technical wizardry and theoretical
sophistication have limited value in practice.
❐ Therefore, in this text, topics typically evolve from a thorough intuitive understanding
through increasing levels of theoretical sophistication up to the theoretical rigour
found in standard intermediate macroeconomics texts.

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In addition, without the ability to situate theoretical insights in the real-life institutional
context, theory becomes almost sterile. The practices of institutions such as the central
bank or national treasury, or ratings agencies and labour unions, often have as large a
bearing on economic processes and outcomes as the behaviour of individuals or businesses.
Also, it is important to have a sense of economic magnitudes: to know when a statistic or
number, mentioned by some commentator or churned out by an analyst, sounds plausible
… or just could not be right.
❐ In this book, pertinent institutional and historical information as well as data tables,
graphs and tips continually reinforce the link between theory (abstraction) and reality.
This also provides a confidence-building experience to students who could easily have a
sense of alienation if confronted with economic theory only.
So what? Let’s reason
To contribute to active learning and a higher knowledge retention rate, the text has been
written in an interactive style. Expositions are interspersed with questions and stimulating
data, or a fascinating institutional backdrop. Students are encouraged to ask questions
about the operation of the economy: Why do things happen? How does the process actually
occur? How do the institutions operate? So what? What happens next? Why does it matter?
Such a habit of thinking and asking questions makes the acquired insights ‘active’ and
ready for application.
In the same way, the policy chapters do not provide recipes to ‘solve’ macroeconomics.
They demonstrate how intelligent economic analysis can help one to think more effectively
and make fewer policy mistakes.
All of this will help to impart to users of the book (both students and practitioners) an
enduring and satisfying understanding of – and the ability to think and reason about –
macroeconomics in South Africa. Exhaustive experience with this approach to lecturing
macroeconomics has shown that students retain significantly more knowledge and
insights, even years afterwards, than with conventional mostly theoretical analysis. They
also feel confident in discussing both theory and its practical aspects – and to think on
their feet.

Learning routes – a choice of difficulty level


A distinguishing characteristic of the book is that the reader can choose to read and engage
with the subject matter, and especially the theory, at different levels of difficulty. Thus it
affords access at different levels of complexity, progressively providing deeper insights and
higher analytical capabilities.
These levels are:
❐ a mainly intuitive route, or level, using chain-reaction arguments in which a sequence of
changes in variables unfold, accompanied by relatively simple theory, basic equations
and basic diagrams; then moving on to
❐ a more theoretical level, where the sequence of changes is depicted and analysed with
more complex equations and diagrammatical aids such as the IS-LM-BP model and the
AD-AS or AD'-PC curves (see below); then, if desired,
❐ a more advanced level, using mathematical derivations and analysis presented in a
parallel series of ‘maths boxes’; these show the relevant mathematical derivations and
manipulations alongside the intuitive, chain-reaction and diagrammatical analyses –
to fully deepen understanding.

x Preface

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Learning how macroeconomic changes unfold: from chain reactions to time-paths
and animations
A key objective is for the reader or student to develop a ‘feel’ for the economy: how
macroeconomic changes in fact are dynamic processes that unfold and evolve, rather than
being jumps from one static equilibrium to the next – which is not how people experience
the economy.
The first tool is the extensive use of chain reactions in analysing economic behaviour. Based
on the basic theories of consumption, investment, etc., the reader learns to construct
sequences of likely effects as disturbances spread from one variable to another and one
sector to another. This creates a real sense of how things unfold over the business cycle or
in response to an external shock or a policy intervention.
Building on this, novel time-path diagrams demonstrate the possible course of several
variables unfolding over time, affording a strong real-world feel to examples of the
consequences of macroeconomic disturbances or policy steps. A related feature is
the explicit clarification of the short, medium and long run. This develops the reader’s
understanding of the time dimension of disturbances and various adjustment processes
in the money market, balance of payments and aggregate supply.
The culmination of this is a new online learning aid, animations of key diagrams, ideal for
the video generation. These are vastly effective in giving readers a sense of dynamics and
changes in the economy. The analysis is not limited to comparing equilibrium points, but
can be seen as ‘live’ dynamic shifts of curves that move a point of intersection on the way
to a new equilibrium. These analytical visuals are paired with the time-path diagrams,
showing the corresponding course of the variables over time live – movies of the economy
changing and adapting to cycles, shocks and policies.
Enthusiastic feedback from lecturers and students indicates that the animations add
significantly to one’s understanding of macroeconomic forces and dynamics. These
animations are available online free of charge to students for use on laptops, tablets and
cell phones and can be accessed on the following websites:
❐ www.ufs.ac.za/macroecon
❐ https://jutapassmasters.co.za/learning/search.php?search=how+to+think
PowerPoint slides of all the diagrams in the book, with hyperlinks to the animations,
are available to lecturers. The slides provide a seamless transition from static diagrams
to animations in the lecture room (providing wi-fi is available). These slides can be
downloaded at:
❐ https://jutapassmasters.co.za/learning/search.php?search=how+to+think
Major features in terms of content
As an integral part of a distinctive approach to teaching macroeconomics and situating
it in the South African context, the book differentiates itself also with regard to content.
Chapter 0 contains some detail on this. Here we only note a few.

Preface xi

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An open-economy approach throughout
An important characteristic of this book is the explicit incorporation of the fact that
South Africa has a very open economy, strongly subject to international economic forces.
Whereas many textbooks consider the macroeconomic implications of international trade
and capital flows only in the final chapters, if at all, here they are incorporated throughout
the text, starting in the first chapters. Chapter 4 sets out these intricacies in depth and
provides a level of analysis not often accessible to readers of macroeconomics textbooks.
This should make the reader very comfortable with discussions of, for example, the balance
of payments, exchange rates, the gold price and the impact of events in South Africa’s
main trade partners on the local economy.

The emerging-market, middle-income and African context


The book illuminates the development context of the South Africa economy. From the
first chapter it situates the standard macroeconomic issues and policy objectives in
the circumstance of South Africa as a middle-income country and emerging-market
economy in Africa. A brief overview of the definition, measurement and analysis of
human development is presented, also with reference to the Sustainable Development
Goals (SDGs). Attention is given to development aspects by means of informative boxes
and explicit discussions of, for instance, the link between economic growth and human
and institutional development, as well as HIV and Aids (see chapters 8 and 12). The
first chapter also includes perspectives on the political-economic elements of race, class,
capitalism and apartheid that continue to shape the economic policy and development
debate in South Africa.

Unemployment – and structural unemployment


There is thorough coverage of the labour market and unemployment, particularly
recognising the role of labour-market features such as segmentation and entry barriers,
as well as the informal sector. This neatly complements a key feature of the book, i.e. the
analysis of structural unemployment – something economists and policymakers need to
engage with seriously. Structural unemployment is included in the theory, data and policy
discussion in several chapters. In the theoretical model the treatment of unemployment
and a long-run equilibrium output level is couched in a way that explicitly accommodates
the existence of structural unemployment and a structural rate of unemployment (SRU)
– while retaining easy comparability with texts and theory from abroad. (Such texts
usually have very little to say about structural unemployment in low- and middle-income
countries.)
The final chapter provides a thorough analysis of the causes of voluntary and involuntary
unemployment – and structural unemployment in particular. This includes possible links
to the development trajectory, demography, health and education status, technology
and capital intensity, sectoral factors, labour unions and labour mobility, social welfare,
migrant labour, etc. This informs a critical discussion of possible policy interventions,
including the limitations of conventional macroeconomic policy instruments to address
this problem.

Supply-side analysis quite exhaustive


In standard textbook presentations of the AD-AS model, the aggregate supply side often
gets only cursory treatment. This book presents a more exhaustive treatment of the

xii Preface

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aggregate supply side (in chapter 6) to match the depth of the derivation of the aggregate
demand side. The short- and long-run aggregate supply (AS) curves are derived from
behaviour in the labour market, using price-setting and wage-setting relationships in a
context that recognises imperfect competition and institutional rigidities in product and
labour markets. Differences between expected and actual prices explain the difference
between the short-run and long-run AS curves as well as related supply adjustment
processes towards a long-run, or structural, equilibrium. This well-grounded derivation
of the AS curve enables a much better analysis of supply shocks, revealing new nuances
and complexities, also in the policy context.

Inflation integrated from the start


Another distinctive feature is having an intensive and integrated treatment of inflation
and the inflationary context. While a variable price level is only formally introduced in the
AD-AS model in chapter 6 and inflation in chapter 7, the distinction between nominal and
real variables is present in the first theory chapters. This enables the investment function
to be stated as a function of the real rate of interest, and the money demand function as
a function of the nominal interest rate. Secondly, in chapter 7, a theoretical framework
is provided that prepares the reader to analyse macroeconomic shocks and adjustments
in a setting where inflation is a permanent phenomenon. It combines an inflation-
augmented AD curve with inflation-augmented AS curves – the short- and long-run
Phillips (or PC) curves. Also included is a discussion of monetary reaction (MR) functions,
typically associated with inflation-targeting policy regimes. The final chapter then deals
exhaustively with the measurement, causes and remedies of inflation in South Africa.

Economic growth theory – in a way everyone can understand


In many macroeconomics courses, growth theory is often disregarded, or otherwise
experienced by students as murky and somewhat disconnected from macroeconomic
models that focus on the business cycle, unemployment and inflation. The treatment
in this book is a natural extension of the theory of aggregate supply in a time frame
stretching from the short and medium run to the long run and very long run. This
presentation of growth theory (chapter 8) provides a novel, intuitive and insightful grasp
of the idea of balanced growth paths. The exposition starts from a simple Solow model,
but soon broadens to include aspects such as social and economic institutions, thus also
linking growth theory to human capital and human development. Here the animations
are particularly useful in grasping the technicalities of one of the more challenging topics
in macroeconomics.
The section in the final chapter on the measurement, causes and remedies of low growth
in South Africa also considers aspects particularly relevant to many African countries,
e.g. human capital, income inequality, institutions, political barriers, culture, trust,
ethnicity, social division and geography. The relationship between economic growth and
the environment is also discussed.

A window on the real worlds of monetary and fiscal policy making


The text conveys a solid feel for the real world of policy making: the difficult choices
policymakers face and the constraints they have to deal with. In addition, the institutional
dimension is incorporated throughout, revealing the actual policy-making processes in
the National Treasury and the Reserve Bank. For example, in addition to analyses of the

Preface xiii

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role and impact of monetary policy steps, chapter 9 explains the key choices in the design
of monetary policy (objectives, instruments, targets, including inflation targeting), as
well as the practice of monetary policy, i.e. monetary monitoring combined with basic
monetary policy making such as the determination of the repo rate by the Monetary
Policy Committee (MPC).
The chapter on fiscal policy is especially rich in this regard, distinguishing this book from
most others. The role and financing of government are central to the intense debates
on service delivery, public sector wages, government expenditure on health or higher
education (or Eskom bail-outs), VAT and income tax, the budget deficit and growing public
debt (and the hazard of ratings downgrades). Chapter 10 provides essential insights and
methods of analysis. It draws extensively on the practical experience of the authors in
either working in or advising the National Treasury, putting across an authentic sense of
how decisions are made in the budget process amidst complex constraints. Also shown is
how to make sense of public finance numbers and use fiscal yardsticks.

Using the national accounting identities as a tool to understand sectoral coherence and
constraints
The national accounts can be a dry subject area, dominated by definitions and accounting
conventions. But one can engage with the topic without doing accounting. Indeed, chapter
5 provides a unique treatment of the national accounting identities: as powerful tools to
bolster logical-intuitive reasoning and analyses of macroeconomic change. It becomes a
tool to understand the accounting-type coherence between sectors of the economy – the
numbers must add up, must balance – as well as underlying constraints on macroeconomic
change and adjustments. Along the way the reader will acquire a working understanding
of the System of National Accounts and important South African data sources.

Extensive case studies and real-world applications


In addition to real-world examples throughout the book, there are several major case
studies with full diagrammatical analysis and animations. These include the 2007–08
international financial crisis, quantitative easing and ‘creative monetary policy’ in the
USA, the Euro-zone public-debt crisis, as well as the ongoing Eskom crisis in South Africa
and its impact on gross domestic product (GDP) growth and inflation.

Changes in the fifth edition


The focus on the South African context, including its status as an upper-middle-income
country in the Southern Africa Development Community (SADC) and Africa, already
was present in the earlier editions. In this edition the quest to integrate the appropriate
context into the analysis has been sharpened and made more explicit, also in data boxes,
applications, examples and exercises.
All policy sections have been freshly updated to incorporate the newest policy approaches
as well as institutional changes in South Africa. Major policy initiatives, such as the
National Development Plan (which appears to be back on the table under president
Ramaphosa), are thoroughly discussed. Also noted are controversies relating to the
mandate and ownership of the Reserve Bank, frequent changes in Ministers of Finance,
the public debt issue, as well as the impact of recent political dynamics. The book retains its
unique, institution-rich treatment of the complex role of government in macroeconomic
relationships, events, policies and official South African data.

xiv Preface

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Other updates include the implications of major changes in South Africa’s international
trade patterns, as well as recent international shocks such as Brexit and US president
Donald Trump’s trade war with China. On the development front it includes sections on
the SDGs and the Inclusive Development Index, developed by the World Economic Forum,
to complement the section on the United Nations Development Programme’s (UNDP)
Inclusiveness Index, which measures inclusive growth.
All data tables and graphs have been updated and new internet sources provided.
Numerous new analytical exercises and questions at the end of chapters engage with
recent developments in South Africa and internationally. These include Brexit, China’s
prominence and the possibility of South Africa having to request assistance – a bail-out –
from the International Monetary Fund (IMF).
August 2019

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Table of contents

Preface��������������������������������������������������������������������������������������������������������������������������������������� ix

0. Introduction and orientation: macroeconomics in the South African


context�������������������������������������������������������������������������������������������������������������������������� 1

Part I How does the economy work?


1. Why macroeconomics? An introduction to the issues
1.1 What is macroeconomics?������������������������������������������������������������������������������������������9
1.2 How can learning to think and reason in macroeconomics help me?����������������������10
1.3 Main macroeconomic problems and policy objectives��������������������������������������������11
1.4 The development objective���������������������������������������������������������������������������������������25
1.5 Intermediate objectives���������������������������������������������������������������������������������������������30
1.6 Conflict between the standard objectives – priorities and trade-offs�����������������������30
1.7 Priority choices of the South African government����������������������������������������������������������31
1.8 Main perspectives in the economic debate in South Africa�������������������������������������33
1.9 Analytical questions and exercises���������������������������������������������������������������������������41

2. The basic model I: consumers, producers and government


2.1 The basic framework�������������������������������������������������������������������������������������������������46
2.2 The real (or goods) sector ����������������������������������������������������������������������������������������50
2.3 Analytical questions and exercises���������������������������������������������������������������������������74

3. The basic model II: financial institutions, money and interest rates
3.1 The monetary sector and interest rates��������������������������������������������������������������������76
3.2 Linkages between the monetary and the real sectors����������������������������������������������98
3.3 The IS-LM model as a powerful diagrammatical aid���������������������������������������������� 109
3.4 Real-world application: The 2007–08 financial crisis – varying investor
behaviour and impotent monetary policy�������������������������������������������������������������� 134
3.5 Analytical questions and exercises������������������������������������������������������������������������ 138

4. The basic model III: the foreign sector


4.1 Background – why trade internationally?��������������������������������������������������������������� 141
4.2 Imports, exports and capital flows������������������������������������������������������������������������� 142
4.3 The balance of payments and exchange rates������������������������������������������������������ 156
4.4 The BoP adjustment process��������������������������������������������������������������������������������� 171
4.5 The complete model – the BoP, the exchange rate and the domestic economy��� 172

Table of contents v

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4.6 Conflict between internal and external considerations������������������������������������������ 186
4.7 The IS-LM-BP model for an open economy����������������������������������������������������������� 188
4.8 Real-world application – the Euro crisis and the impact of confidence
on international capital flows��������������������������������������������������������������������������������� 204
4.9 Analytical questions and exercises������������������������������������������������������������������������ 210

5. Understanding sectoral coherence and constraints: how to use


macroeconomic identities
5.1 From equilibrium conditions to identities��������������������������������������������������������������� 214
5.2 The interpretation of identities – uses and abuses������������������������������������������������ 216
5.3 Expenditure, production and current account deficits������������������������������������������ 219
5.4 The sectoral balance identities������������������������������������������������������������������������������ 219
5.5 The financing of gross capital formation���������������������������������������������������������������� 225
5.6 The SNA at a glance – relationships between subaccounts���������������������������������� 228
5.7 Using the sectoral balance identities for decision making������������������������������������ 232
5.8 Analytical questions and exercises������������������������������������������������������������������������ 234
Addendum 5.1: National accounting definitions and conventions –
a student’s guide�������������������������������������������������������������������������������������������������������������� 235

6. A model for an inflationary economy: aggregate demand


and supply
6.1 Essentials of the AD-AS model������������������������������������������������������������������������������ 241
6.2 Aggregate demand (AD)����������������������������������������������������������������������������������������� 243
6.3 Aggregate supply (AS)�������������������������������������������������������������������������������������������� 249
6.4 Aggregate supply (ASLR, ASSR) and aggregate demand (AD) together������������������� 272
6.5 Real-world application – the Eskom crisis, GDP and prices���������������������������������� 294
6.6 Analytical questions and exercises������������������������������������������������������������������������ 299
Addendum 6.1: Labour market changes following demand stimulation������������������������� 300
Addendum 6.2: Labour market details following a domestic supply shock�������������������� 301
Addendum 6.3: A complete example of IS-LM-BP and AD-AS for an increase
in the repo rate������������������������������������������������������������������������������������������������������� 302
Addendum 6.4: A complete example of IS-LM-BP and AD-AS for an increase
in the price of imported inputs (e.g. oil)����������������������������������������������������������������� 303

7. Extending the model: inflation and policy reactions


7.1 Adjusting the model – inflation-augmented AD and AS curves����������������������������� 306
7.2 Managing inflation – policy options and the monetary reaction (MR) function����� 320
7.3 Analytical questions and exercises������������������������������������������������������������������������ 327

8. Macroeconomics in the very long run: growth theory


8.1 The importance of growth�������������������������������������������������������������������������������������� 329
8.2 Why growth theory?����������������������������������������������������������������������������������������������� 330
8.3 From intuition to formal analysis – from AD-AS to the Solow growth model��������� 332
8.4 Rearranging the model – towards income per capita�������������������������������������������� 336
Y
8.5 Sources of sustained growth in ​   ​​– first conclusions�������������������������������������������� 338
N
8.6 Is any capital–labour ratio possible? The idea of balanced growth����������������������� 340
8.7 Expanding the model – the expanded balanced growth condition����������������������� 344

vi Table of contents

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8.8 Using the model – changes in the balanced growth path due to
changing parameters��������������������������������������������������������������������������������������������� 348
8.9 Convergence between low-and-middle-income and high-income countries?������ 354
8.10 Human capital – the previously missing element��������������������������������������������������� 355
8.11 Summary and conclusions������������������������������������������������������������������������������������� 358
8.12 A last word on growth (for now …) ������������������������������������������������������������������������ 361
8.13 Analytical questions and exercises������������������������������������������������������������������������ 362
Addendum 8.1: The Cobb-Douglas production function������������������������������������������������� 363
Addendum 8.2: An illustration of balanced growth – the course of ratios between
key variables����������������������������������������������������������������������������������������������������������� 365

Part II Macroeconomic policy, unemployment, inflation and growth


in an open economy
9. Monetary policy: the role of the Reserve Bank
9.1 Definition and main instruments���������������������������������������������������������������������������� 371
9.2 Monetary policy design – four important choices�������������������������������������������������� 376
9.3 Inflation targeting in South Africa��������������������������������������������������������������������������� 380
9.4 The practice of monetary policy����������������������������������������������������������������������������� 383
9.5 Public debt management – the interface between financial markets and
fiscal and monetary policy������������������������������������������������������������������������������������� 386
9.6 Exchange rate policy and the problems of monetary policy in an
open economy�������������������������������������������������������������������������������������������������������� 389
9.7 Real-world application – quantitative easing and ‘creative monetary policy’
in the USA��������������������������������������������������������������������������������������������������������������� 392
9.8 Monetary policy and the ownership of the Reserve Bank������������������������������������� 394
9.9 Analytical questions and exercises������������������������������������������������������������������������ 394

10. Fiscal policy: the role of government


10.1 State, government and public sector��������������������������������������������������������������������� 397
10.2 Definition and instruments of fiscal policy������������������������������������������������������������� 397
10.3 The choice of overarching policy objectives���������������������������������������������������������� 402
10.4 Constraints on fiscal policy choices���������������������������������������������������������������������� 405
10.5 The decision on the main fiscal aggregates����������������������������������������������������������� 411
10.6 Public debt and public debt management������������������������������������������������������������� 431
10.7 Fiscal discipline and fiscal norms�������������������������������������������������������������������������� 436
10.8 Fiscal policy and development – broader criteria�������������������������������������������������� 451
10.9 Analytical questions and exercises������������������������������������������������������������������������ 452
Addendum 10.1: Measuring aggregate government expenditure����������������������������������� 454
Addendum 10.2: Measuring government revenue and the deficit����������������������������������� 459

11. Policy problems: coordination, lags and schools of thought


11.1 Monetary vs. fiscal policy?������������������������������������������������������������������������������������� 461
11.2 Policy problems������������������������������������������������������������������������������������������������������ 464
11.3 The larger problem – different schools of thought������������������������������������������������� 467

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12. Inflation, unemployment and low growth: causes and remedies
12.1 Inflation������������������������������������������������������������������������������������������������������������������� 481
12.2 Unemployment������������������������������������������������������������������������������������������������������� 501
12.3 Low economic growth�������������������������������������������������������������������������������������������� 528
12.4 Inclusive growth and development������������������������������������������������������������������������ 553
12.5 Policy design in practice – the National Development Plan����������������������������������� 558
12.6 A final thought – the structural dimension of macroeconomic problems�������������� 564
12.7 Analytical questions and exercises������������������������������������������������������������������������ 565

Index��������������������������������������������������������������������������������������������������������������������������������������������� 568

viii Table of contents

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