Digital Money and Monetary Control

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Nov 15, 2013 (4 years and 7 months ago)


Digital Money and Monetary Control

Aleksander BERENTSEN <>

University of Bern



This paper considers the implications of digital money for monetary control. For this purpose,
it first investigates the po
tential of digital money to replace central bank currency.
Considering its characteristics only, digital money could eventually become the dominant
payment instrument for small value payments. The main obstacles to its success, however, are
network externa
lities. These externalities are discussed in a simple game
theoretic model in
which buyers and sellers decide whether to use digital money or central bank currency for
payments. The paper then studies the implications of a complete replacement of central b
currency. Here, the main problems for central banks are the loss of seigniorage income and
the nontrivial reduction of total liabilities and assets, which adversely affect monetary control.
It ends with a discussion of the measures that central banks c
an take to prevent these



Replacing central bank currency

Network Externalities

Monetary control


Effects on the demand for reserves


Supply of reserves

Central bank response





The possibility that consumers could start paying for

retail purchases with digital money,

once it becomes established, instead of with paper money, has begun to alarm central bankers,
the media, and scholars and has recently initiated
a number of studies. The main examples are
two papers published by the Bank for International Settlements (BIS 1996a and BIS 1996b).
BIS (1996b) considers the implications of the development of digital money for central banks
in such areas as monetary poli
cy, supervision and regulation of financial intermediaries, and
supervision of the payment system.

BIS (1996a) focuses on the security of digital money products, which is the major concern of
central bankers today. A security breach


f a widely used digital money
product could rock the financial system. In addition, there is concern that digital money could
facilitate money laundering, fraud, and tax evasion; illegal activities could be facilitated by
widespread use of digital money be
cause, in contrast to debit card and credit card
transactions, some forms of digital money allow users to remain anonymous. For banking
supervisors, the main issues are whether institutions, other than banks, should be allowed to
issue digital money, and w
hether traditional regulations, such as reserve requirements and
capital regulations, should be extended to all issuers of digital money. The European Union,
for example, plans to limit the issuance of multipurpose smart cards to registered banks only


Digital money proposals are based on either the smart card or computer network money. The
smart card (also known as the electronic purse) is a plastic card with an embedded
microprocessor that can be loaded with a monetary value. The card's value
is reduced with
each purchase. Reloadable, the smart card needs no online authorization for value transfer and
can be used for many different purposes. In contrast, the single
purpose, prepaid cards (e.g.
telephone cards) widely used in Europe are neither
reloadable nor can they be used for
multiple purposes. The main difference between the smart card and debit card is that the use
of a smart card initiates a transfer of a medium of exchange, i.e., digital money, that is stored
on the smart card. In contras
t, the use of a debit card initiates a transfer of a medium of
exchanges, i.e., demand deposits, which is stored on the transaction account of the payer.
Thus, for a debit card payment an online connection is needed. Basically, network money is
software th
at allows the transfer of value on computer networks, particularly on the Internet.

Like a demand deposit, digital money is

money, whereas central bank currency is

money. Inside money gives the bearer a legal claim against its issuer; outsi
de money
entails no such claim (Hellwig 1985). Like a travelers check, which is also inside money, a
digital money balance is a floating claim on a private bank or other financial institution that is
not linked to any particular account (White 1996). The i
ncentive for an institution to issue
digital money is the interest
free or low
interest debt financing that its outstanding balance

This paper examines how widespread use of digital money would affect monetary control. It
considers digital money
's potential to replace paper currency because its principal threat to
monetary control stems from its potential to replace central bank currency, which in most
countries is by far the largest component of central bank liabilities. We also evaluate possibl
central bank responses to the development and spread of digital money.

Replacing central bank currency

Digital money products, based on smart cards, are designed to facilitate small
value payments
in face
face retail transactions. The average transac
tion is expected to be less than $20, a
sum for which use of credit and debit cards is inconvenient and too costly (CBO 1996). It is
therefore expected that digital money based on smart cards will reduce use of central bank
notes and coins and, to a much l
esser extent, use of debit and credit cards for face
payments. Software
based digital money products are more likely to reduce use of checks,
debit cards, and credit cards for non
face payments, i.e., for online payments.

Many different ty
pes of digital money with varying characteristics are currently being
developed. In principal, however, digital money can be designed to share all characteristics of
central bank currency, and can be seen, therefore, as a very close substitute for bank not
es and
coins. Table 1 lists the main characteristics of currency, digital money, checks, and debit
The main differences between digital money and currency are:


Digital money is not legal tender, which reduces its acceptance initially.


Digital mone
y, unlike currency and other payment instruments such as debit cards,
credit cards, and checks, does not

require the physical presence of payer and payee for
payment finality

because digital money balances can be transferred across
telecommunication networ
ks in real time.


Digital money is expected to reduce the marginal cost of a transaction substantially.

Replacement of currency could benefit issuers, consumers, and merchants. Issuers would
benefit from the interest
free debt financing provided by digita
l money balances. Today,
almost all proposed digital money schemes are developed by private institutions. The issuer,
however, could also be a central bank. Consumers would benefit from the convenience. For
merchants, accepting digital money would reduce c
osts if bits and bytes replaced physical
coins and notes.

The estimated annual costs of handling central bank currency by U.S. retailers and banks are
$60 billion; this total includes costs of processing and accounting of money, storage,
transport, and se
curity (Hayes et al. 1996). Hayes et al. (1996) also suggests that the cost of an
electronic payment ranges between one
third and one
half of a paper check or paper giro
payment. Beside cost savings, Hayes et al. (1996) suggest additional advantages of usi
digital money including an expected reduction in some forms of fraud, greater safety and
security, and a potential for value
added services. An indication of the low cost per
transaction: several money schemes under development would allow (online) paym
ent for
services (e.g. downloading a newspaper article) that cost less than one cent (micropayments).

Table 1 compares the characteristics of digital money, curr
ency, checks, and debit cards. In
many respects digital money has the same characteristics as currency. However, it is the only
payment instrument that can provide payment finality in non
face transactions. This
property and the low costs per trans
action make digital money the ideal candidate for
payments across public computer networks.

A property not mentioned in Table 1 is robustness of a payment instrument against fraud,
technical problems, or changes such as the year 2000 problem and the intro
duction of the
Euro. In this respect the rating would be less favorable for digital money. An anonymous
referee suggested a rating of No, Yes, Yes, and yes. The main reason for the poor rating of
digital money with respect to this property is that after an

unexpected change the software on
all smart cards and computers would have to be exchanged. The decentralizes nature of digital
money makes such changes very costly. In a more centralized payment system, such as the
credit card business, the costs of such

changes are expected to be less.

While digital money products based on smart cards would mainly reduce demand for
currency, software
based digital money products could also affect demand for demand
deposits due to
reduced transaction costs

learning sp
. Software
based digital
money could facilitate and reduce the cost of transferring value among different types of
accounts, banks, and countries.

The second reason

learning spillovers


refers to the notion that using software
digital m
oney will improve the skills of those using personal finance software and
telecommunication technologies to optimize their financial planning. Personal finance
computer software tracks income and outgo and helps in creating budgets, managing
investments, a
nd filling out tax forms. It also can access electronic banking and electronic bill
payment services.

With these software products, small businesses and households will be able to monitor

holdings more frequently and to automate basic tasks.

One da
y, for example, software agents
could possibly automatically invest short
term excess liquidity overnight for ordinary
households. It is difficult to predict the quantitative effects of these developments on the
demand for transaction deposits. However, lo
wer transaction costs and more frequent
adjustments of money holdings suggest a lower demand for demand deposits.

Network Externalities

This comparison of digital money and central bank currency suggests that digital money is a
serious competitor to centr
al bank currency. It is possible, therefore, that digital money could
replace the
entire stock

of central bank currency. The main obstacles to its success, however,
are network externalities. The benefit of using any money product depends on its popularity
If few merchants accept digital money, households using digital money will find few benefits.
Similarly, if few consumers use digital money, merchants will have little incentive to accept
digital cash. These network externalities suggest that even though

use of digital money would
benefit firms and households, paper currency will not be replaced easily. Issuers of digital
money schemes will have to convince consumers and merchants that their product will
succeed in the market against other digital money s
chemes as well as those other popular and
traditional media for small value payments, checks and cash.

In the following we consider a simple game theoretic model that captures these network

The starting point, i.e., the status quo, is the
existence of a generally accepted
medium of exchange used to pay for all purchases in the economy. At some point, a private
entity launches a new type of money with favorable properties for shop owners and
consumers. Use of the new money requires an initia
l investment by both firms and consumers.
Each agent has to decide whether he or she wants to use the new money. The rate of return on
the investment depends on how many agents decide to invest. Thus, like a telephone network,
the incentive to participate
depends on the number of users. If only a few merchants accept
digital money, why would a consumer acquire a smart card or network money? At the same
time, if only a few consumers are using smart cards, why would a merchant invest in
equipment to process d
igital money?

The model is simple: There is one consumer and one shop owner and one transaction between
the two.

Both parties have to choose whether to use the old or the new money to pay for the
transaction. Old money is denoted
by M

and is called
. Use of cash costs

for both
consumer and shop owner. The new medium, named
digital cash
, is denoted by
. Use of
digital cash requires from both parties an initial investment expenditure
. Use of digital cash

for both consumer and shop owner
. Digital cash has superior characteristics for both
merchant and consumer; in particular, total costs for both parties are smaller when they use
digital cash, i.e.,



Of course, profitability of investment depends on whether both parties use d
igital cash. The
probability that the shop owner invests in digital cash is denoted by
and the probability that
the consumer invests in it is denoted by
. When

denotes the revenue of the transaction,
the profit function for the shop owner is:



The shop owner chooses

to maximize (1). The best response correspondence is given by
the following rule:

, the shop owner does not invest;

, the shop owner invests in digital cash; and

, the shop owner is indifferent.

Note: The larger the investment,
, and the larger the transaction cost of
digital cash
, the
less likely that the shop owner will invest in

digital cash
. Also, the larger the transaction cost
, and the larger the probability that the consumer will use
digital cash
, the more
likely that th
e shop owner will invest in
digital cash
, the new medium of exchange. Next,
consider the consumer who has to decide whether to make the investment. The consumer's
expenditure function is:


The consumer chooses

to minimize expenditure
. The best response correspondence is
given by the following rule:


, the consumer does not invest;


, the consumer invests in digital cash; and


, the consumer is indifferent.

Figure 1: Best response corresponden
ces of shop owner (dashed curve) and consumer (solid
curve) who have to decide whether to use the new media of exchange. The best response of
one party depends on the planned action of the other party.

The best response correspondences of the consumer and
of the shop owner are shown in
Figure 1. There are three (Nash) equilibria in this game. In the first equilibrium, A, digital
cash is not used, even though it would be less costly for both parties. In the second
equilibrium, B, cash and digital cash are us
ed simultaneously and in the last equilibrium, C,
only digital cash is used.

Note further that, even with zero investment cost equilibria, A prevails. If the consumer does
not use digital cash, a best response for the shop is not to accept digital cash. A
nd, given that
the shop does not accept cash, a consumer's best response is not to use cash. We have kept the
model simple, but even in a more realistic setup the basic problem of strategic interaction
remains: The behavior of one party depends upon the ex
pected action taken by the other

The model suggests that even when replacement of central bank currency would benefit firms
and households, cash wouldn't be replaced as easily. Issuers of one kind of digital money
would have to convince consumers a
nd shop owners that their investment would have a
positive rate of return; basically, this means that their particular technology would succeed in
the market against other digital money schemes and traditional media. It also suggests that
convincing agents

to use digital money will make implementing digital money schemes

Monetary control

Monetary control is based on the ability of central banks to determine the conditions that
equilibrate demand and supply in the market for bank reserves. In this m
arket central banks
are monopolistic suppliers of reserve assets and they can also directly affect demand, for
instance, by setting reserve requirements and by shaping and operating key interbank
settlement systems (Borio 1997). Central banks can either de
cide to control the total quantity
of reserves or the price at which they are traded among banks. In most countries central banks
aim at stabilizing the short
term interest rate at which banks trade these reserves. In the
following we study the impact of d
igital money on the demand for bank reserves (deposits at
the central bank) and discuss the implications for monetary control.

Effects on the demand for reserves

Banks hold reserves for two reasons. (1) In many countries they are required to hold a
tage of certain types of deposits as reserves. The percentage and the types of deposits
that require holding reserves differ from country to country. (2) Banks hold reserves for
settlement purposes to cushion costly daytime and overnight overdrafts. The ty
pes of liquid
assets that are counted as reserves differ from country to country. Most reserves, however, are
held as book entries at the central bank and as vault cash, i.e., central bank currency holdings
of banks.

In the market for reserves, banks trade

reserves to meet reserve requirements and to adjust
settlement balances. The price for these reserves is the primary interest rate with which central
banks influence through their monetary instruments. A permanent change in the price for
reserves influenc
es other money and credit rates and, eventually, the real sector of the
economy and the price level.

Demand for reserves depends crucially on the institutional arrangements prevalent in a
country and these institutional arrangements differ from country to
country. They pertain to
the existence of (binding) reserve requirements, the nature of payment and settlement
procedures, the types of eligible reserve assets, and the conditions of central bank assistance
(standing facilities). For an excellent, detailed

description of institutional arrangements in
several industrial countries consider Borio (1997).

The banking systems' demand for reserves
to meet reserve requirements

depends on the
public's demand for reservable deposits and reserve ratios. Demand for re
serves would be
reduced if digital money were to become a substitute for reservable deposits. Section 1
suggested that software
based digital money could reduce demand for transaction deposits.
The Bank of International Settlements (1996b) suggests, howeve
r, that substitution of
reservable deposits would be small: "It is conceivable that a very extensive substitution [of
reservable deposits] could complicate the operating procedures used by central banks to set
money market interest rates. However, since e
money is expected to substitute mostly for cash
rather than deposits, it is highly unlikely that operating techniques will need to be adjusted

During the 1990s, many industrial countries have radically reduced their reserve
requirements. Fo
r example, since 1990, reserve requirements have been reduced in all of the
major (G7) industrial countries (Bisignano 1996). Today, Belgium and Sweden have no
reserve requirements in place. Digital money could reduce demand for reserves indirectly by
ng to this trend, particularly those software
based products that facilitate and reduce the
cost of transferring value among different types of accounts, banks (and nonbanks), and

If bank customers were to use digital money extensively, the pres
sure on central banks to
reduce reserve ratios and the number of types of reservable liabilities would increase. This
would be particularly true if foreign intermediaries were to increasingly attract (transaction)
deposits of domestic residents across publ
ic computer networks; central banks would be
pressed then to lower reserve ratios to help domestic banks compete for domestic (and
foreign) deposits.Reserve requirements are basically a tax on financial intermediation; banks
subject to reserve requirements

are at a competitive disadvantage compared with nonbank
financial intermediaries offering close financial substitutes. A study by the Bank of Japan
(1995) on the recent reform of reserve requirements in major industrial countries suggests that
the main re
ason for reducing reserve requirements has been to lower the "burden"
("distortion", "inequality") on depository institutions (Bisignano 1996).

Without reserve requirements or where reserve requirements are nonbinding, demand for
bank reserves is essential
ly a
demand for settlement balances
. Demand for reserves would be
affected if digital money were to change the need for settlement balances. In the absence of
reserve requirements, a bank would still want to hold reserves to meet unforeseen liquidity
rawals by its customers. However, the holding of reserves is costly and banks have to
choose the optimal amount of reserves to hold.

This basic liquidity management problem is presented in Baltensperger (1980).

During a
given period, a bank faces a stocha
stic outflow of deposits,
, with density function,
). At
the beginning of the period the bank has reserves,
. If at the end of the period

, the
bank has a res
erve deficiency and has to bear the cost


measures the cost per unit
reserve deficiency. Holding reserves is costly, too, because reserves could alternatively b
invested and earn a rate of return of

In the absence of reserve requirements, the bank chooses its reserve level so that the marginal
cost of reserve holdings,
, equal the marginal return of holding additional reserves, i.e.,


Digital money would affect the demand for reserves if it were to change the cost of reserves,
, the unit cost of reserve deficiency,
, or the probability that a reserve deficiency


. There is no reason to believe that digital money per se would affect either
of these parameters. The rate of return on loans,
, is determined by demand
and supply in the
market for loans and should not be affected by the emergence of digital money. Equally, the
unit cost of reserve deficiency,
, is determined by the conditions of central bank assistance
and the cost of selling illiquid assets at short no
tice, and should as well not be affected by
digital money. Finally, digital money per se should not affect the probability that a reserve
deficiency occurs.

Thus, the liquidity management approach suggests that digital money would not reduce
demand for set
tlement balances importantly. This implies that, even with zero reserve
requirements or even when digital money extensively substitutes for reservable deposits, the
settlement function of central banks would continue to guarantee an ongoing demand for
rves. Reserves may not be used as a medium in which to store value overnight and longer,
but it still would be required as a vehicle for transferring value during a day (Jordan
1996). Havrilesky (1987) suggests that this demand would be sufficient
for the monetary base
to remain a viable policy instrument and that open
market operations would work as they do

Supply of reserves

Initially, substitution of central bank currency would increase cash holdings of banks since
customers would return
excess cash. Banks would observe that their cash holdings exceeded
the optimal amount and they would return cash to the central bank, thereby increasing their
reserves on the books at the central bank. Consequently, substitution of central bank currency
uld increase the total supply of reserves. Substitution of central bank currency, therefore, is
equivalent to an

open market operation that provides additional reserves to the
banking system (Berentsen 1997).

Central banks could be forced to s
tep in and absorb these reserves by selling central bank
assets. Because currency is by far the largest liability of central banks, an extensive
substitution could reduce the monetary base to the extent that it would adversely affect
monetary control. This

concern has been raised by BIS (1996b):

"Since cash is a large or the largest component of central bank liabilities in many countries, a
very extensive spread of e
money could shrink central bank balance sheets significantly. [...],
special circumstances
could arise in which the central bank might not be able to implement
absorbing operations on a large enough scale (for example, to sterilize the effects of
large purchases in the foreign exchange markets) because it lacked sufficient assets on its
balance sheet".

The special circumstances mentioned in the BIS report refer mainly to times when exchange
rate commitments of central banks are challenged by market forces. To keep exchange rates in
line, central banks intervene in the foreign exchange mar
kets by either buying or selling
foreign currency in exchange for domestic. These exchange rate operations affect the system's
liquidity. In fact, the net creation of liquidity through foreign channels can be huge,
amounting in some cases to large fraction
s of the outstanding stock of policy instruments
(Borio 1997).

When exchange rates come under upward pressure, the main problem is to absorb excess
liquidity created by the selling domestic currency in exchange for foreign. The main risk is
that the centra
l bank may not have enough assets to sell to withdraw the liquidity. When
exchange rates come under downward pressure, central bank purchases of domestic currency
for foreign absorb liquidity. In this case, the risk is that central banks may not succeed in

injecting sufficient funds to meet the minimum settlement balance needs of banks, thereby
effectively losing control over short
term rates and disturbing the settlement process (Borio

If all currency were to be replaced, the potential reduction of total liabilities would be
nontrivial, as can be seen in the six industrial countries presented in Table 2. The table's first
column lists total liabilities, the

second column total currency, and the third column the
asset ratio. In Germany, for example, a replacement of the Deutsche Mark
would shrink total liabilities of the Deutsche Bundesbank by 70 percent. In the United States,
a complete sub
stitution of central bank notes would reduce total liabilities and assets by 87

Central bank response

Besides affecting monetary control, replacement of central bank currency would reduce
seigniorage income of central banks considerably. In many
countries, central bank
independence is based on the ability to generate more than sufficient seigniorage income to
pay for operations. There is some concern that an extensive substitution of central bank
currency could reduce seigniorage revenue to the ex
tent that central banks would have to turn
to other income sources such as government subsidies. However, Boeschoten
Heblink (1996),
who studies the potential seigniorage loss of central banks in the G
10 countries, suggests that
the share of seigniorage i
ncome used by central banks to pay for their expenses is small. This
implies that even an extensive substitution of central bank currency would not force central
banks to rely on other income sources.

Nevertheless, it is likely that central banks will tak
e measures to prevent the loss of
seigniorage income and to avoid the adverse effects on monetary control of a replacement of
central bank notes and coins.
Central banks could take the following measures:

They could legally restrict the issuing of digital


They could issue digital money themselves.

They could demand (high) reserve requirements on digital money balances.

Legal restrictions to prevent proliferation of digital money will be difficult to justify,
especially in light of efforts to dere
gulate and improve the efficiency of the financial sector.
Moreover, measures that prevent development of digital money products will result in a
competitive disadvantage; nations that do develop these products will then be able to take the
lead in a cruci
al technological sector. In addition, because digital money can easily cross
international borders, it will be difficult to prevent the use of foreign digital money products
that could eventually emerge as a new medium of exchange in the home country.

tral banks could provide digital money in the same way as they provide paper currency
right now. The Bank of Finland, for example, is developing a cash
card system through its
corporate subsidiary, Avant Finland Ltd. (Bernkopf 1996). Most central banks, ho
wever, have
remained passive in this respect. There is concern that central banks issuing digital money
products could limit competition and reduce incentives in the private sector to innovate more
digital money products.

Central banks could require reser
ves on digital money balances. Reserve requirements, which
are a tax on digital money, could reduce the private sector's incentive to issue digital money
and could hold back or even prevent the private sector's incentive to invest in the development
of dig
ital money products.


In addressing digital money's potential to replace central bank currency, this paper suggests
that digital money poses a credible threat to paper currency because it is specifically designed
to make small value payments in ret
ail transactions and because it could reduce transaction
costs for consumers and businesses.

The main obstacle to its success, beside legal restrictions, are network externalities, i.e., the
benefit of using a particular digital money product depends on t
he number of its users. If few
merchants accept digital money, the benefits to households to use it are low. Similarly, if few
consumers use digital money, a merchant has little incentive to accept it. These network
externalities suggest that even though u
se of digital money could benefit firms and
households, paper currency would not be replaced easily. Issuers of digital money will have to
convince consumers and shop owners that their product will succeed in the market against
competing digital money sche
mes and traditional media.

In examining the impact of digital money on demand for bank reserves, this paper suggests
that digital money could reduce, to some extent, demand for bank reserves to meet reserve
requirements. Demand for settlement balances is
likely to be unaffected because digital
money does neither affect the need for settlement balances nor does it affect the

of holding reserves. This implies that both the settlement function of central banks and
their reserve requirements w
ould guarantee an ongoing demand for reserves.

The main effect of digital money would be on the supply side, i.e., on monetary control. In
most countries, currency is by far the largest component of the total liabilities of central
banks. Replacement of c
entral bank currency would extensively shrink total liabilities (and
consequently total assets) and limit the central banks' ability to control the economy. In
particular, when market forces challenge exchange rate commitments, central banks may not
be abl
e to successfully sterilize liquidity generated by foreign market intervention.

Section 3 considered three possible reactions of central banks: They could legally limit the
proliferation of digital money products, they could issue digital money themselves
, or they
could demand high reserve requirements on digital money balances. The drawback of these
measures is that they would reduce the private sector's incentives to invest in developing
digital money products. However, because of expected losses of seig
niorage income and
predicted adverse effects on monetary control, it is likely that central banks will resort to one
or several of these measures. Initially, it is most likely that they will remain passive and
observe whether digital money transactions wil
l gain a nontrivial share among all payments.
If so, they could try to impose legal restrictions on the use of this new payment instrument
and impose reserve requirements on digital money balances to hold back its further
development. In the long run, howe
ver, some central banks might also start issuing digital
money themselves.


* I would like to thank an anonymous referee, Yvan Lengwiler, Daniel Heller, Marianne
Bürgi, Michel Peytrignet, Daniel Rubinfeld, and Kevin Siegel for their helpful suggestio
and the Swiss National Science Foundation for its financial support. I'm particularly indebted
to Heidi Seney whose comments have improved this paper considerably. This paper draws on
my article "Monetary Policy Implications of Digital Money", which app
eared in Kyklos
(International Review of Social Science) 51, Fasc.1, 89

1. Literature on digital money has created many other expressions such as e
money, electronic
money, network money, digital currency, electronic currency, digital cash, electroni
c cash, e
cash, etc. For an extended definition and characterization of digital money see BIS (1996a,
1996b) Stuber (1996), or CBO (1996).

2. Software agents are intelligent programs that can simplify the processing, monitoring, and
control of digital tra
nsactions by automating many activities.

3. Consider also Dowd and Greenaway (1993) for a model of currency competition and
network externalities.

4. The model can be extended in several directions. The set up could be made dynamic such
that agents would

repeadedly use a given payment instrment. On could also introduce several
competing payment instruments which, for example, would differ in their cost structure.

5. Many authors have modeled in different variations the liquidity management problem of
ks (see Baltensperger 1980). The discussion that follows is based on his exposition.


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