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The sign extension rule for two's complement numbers involves extending the most significant bit (the sign bit) to the left when converting a smaller bit-width number to a larger bit-width representation. If the sign bit is 1 (indicating a negative number), the new bits added on the left are also set to 1; if the sign bit is 0 (indicating a positive number), the new bits are set to 0. This rule is essential when performing operations or comparisons involving different bit-width integers to ensure the correct value is interpreted, particularly in arithmetic operations or when interfacing between different data types.

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