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When you set maximum image dimensions and check off the "Automatically resize uploaded images that exceed size" box, images that exceed the dimensions will be resized as they are uploaded. This means you can upload any size image. If you leave the box unchecked, images that exceed the dimensions will not be uploaded.
Checking "Automatically create thumbnails" will give you the option of displaying a thumbnailed version of your image when it is placed in the article. The thumbnail will be created with the dimensions you specify here.
An important thing to remember here is that if an image is cropped it will keep the same proportions.
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