SSRN Id1995105

Solving the two-period consumer choice model with
Excel-Solver
Jose I. Silva
Corresponding Author
Departament d’Economia
Universitat de Girona
Campus de Montilivi 17071
Girona, Spain
+34-972-418779
jose.silva@udg.edu
Angels Xabadia
Departament d’Economia
Universitat de Girona
Campus de Montilivi 17071
Girona, Spain
+34-972-418236
angels.xabadia@udg.edu
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https://ssrn.com/abstract=1995105
Solving the two-period consumer choice model with
Excel-Solver
In this paper we present a classroom exercise where students can solve the basic two-period
consumer choice model using the Excel-Solver, and explore the main features of the model.
We also include a static comparative analysis and a borrowing constraint in the optimization
problem.
Keywords Intertemporal Consumer Choice Model, Excel-Solver, borrowing constraint.
JEL codes A22, D91, C65
INTRODUCTION
The advances of Information Technologies in last decades have been remarkable. The
presence of personal computers both in domestic and professional environments, as well as
their increased capacity of memory and speed of calculation, has substantially altered
education capabilities. The use of computer in higher education allows part of the time that
was previously devoted to the study of specific analytical procedures for solving particular
problems to be saved. This time can be used to reinforce more general aspects of the
discipline; therefore, the teaching can focus on the interpretation of results beyond their
computation.
In economics, students’ work in the computer labs comes to largely replace traditional
laboratories in other experimental disciplines. The basic function of applied sessions in these
labs is to improve the students’ skills of intuitive judgment without the inconvenience of the
realization of tedious and long calculations. Its power can be summarized using the words of
an old Chinese proverb: I hear and I forget; I see and I remember; I do and I understand.
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Within the range of available resources, such as statistical packages, mathematics programs
and more general software, spreadsheets have become one of the more widespread uses of
personal computers in undergraduate Economics. In particular, Microsoft’s Excel Solver has
been described as a user-friendly and flexible tool for economic optimization (MacDonald
1996). Since the introduction of computers in the classroom, several authors have developed
Excel spreadsheets to solve economics problems (Mixon and Tohamy 1999, Nævdal 2003,
Strulik 2004, Gilbert and Oladi 2011). However, we are not aware of any paper that presents
an application to solve the two-period consumer choice model. In this article we present a
classroom exercise where students can solve the basic two-period consumer choice model
using the Excel-Solver.
As it is well known, the economist Irving Fisher developed a model that allows economists to
analyze how rational, forward-looking consumers make intertemporal choices. According to
the model, when people decide how much to consume and how much to save, they consider
both the present and the future. The more consumption they enjoy today, the less they will be
able to enjoy tomorrow. In making this tradeoff, consumer must look ahead to the income
they expect to receive in the future and to the consumption of goods they hope to be able to
afford.
The two-period version of the model is generally taught at the undergraduate level. Some
macroeconomics textbooks including this model are Abel and Bernanke (7th ed), Burda and
Wyplosz (5th ed) and Mankiw (6th ed). In general, students learn how to solve this model
analytically, which in turn requires to use some mathematical optimization tools. In this paper
we introduce a complementary classroom exercise that solves the standard two-period model
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using the Excel-Solver. Along this line, the model can be taught to students without the
knowledge of calculus. This exercise also permits to do comparative static analysis in an easy
way. Furthermore, the basic model assumes that the consumer can borrow as well as save. Yet
for many people with limited access to credit such borrowing is impossible. We also include a
borrowing constrain into the Solver’s problem to analyze its implications.
THE TWO-PERIOD MODEL
The model is taken from the Mankiw’s macroeconomics textbook (5th edition, chapter 16).
The intertemporal choice model includes the consumer constraints, his preferences, and how
these constraints and preferences together determine his choices about intertemporal
consumption and saving. It is assumed that the consumer lives only two periods. He is young
in period one and old in the second period. The consumer earns income Y1 and consumes C1
in period one, and earns income Y2 and consumes C2 in period two. Moreover, the consumer
has the opportunity to borrow or save in the first period to accomplish his consumption
purposes. Thus, consumption in one of the periods can be either greater or less than income in
that period. In the first period, consumption equals income minus saving. That is,
C1  Y1  S , (1)
where S is saving. In the second period, consumption equals the second-period income plus
the accumulated saving, including the interest earned on that saving. That is,
C2  Y2  (1  r )S , (2)
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where r is the real interest rate.
Note that the variable S can represent either saving or borrowing and that the equations hold
in both cases. If first-period consumption is less than first period income, the consumer is
saving, and S is greater than zero. If first-period consumption exceeds first-period income, the
consumer is borrowing, and S is less than zero. For simplicity, we assume that the interest rate
for borrowing is the same as the interest rate for saving.
Isolating S in the constraint (1) and replacing its value in (2), the following intertemporal
budget constraint is obtained
C2 Y2
C1   Y1  . (3)
(1  r ) (1  r )
It implies that the present discounted value of consumption, that is the sum of today’s and
tomorrow’s consumption valued in terms of goods today, must equal the present discounted
value of the income earned.
The consumer’s lifetime utility regarding consumption in the two periods can be represented
by the following equation,
U (C1 , C2 )  ln C1    ln C2 , (4)
where β is between zero and one and measures consumer’s degree of impatience for
consumption during the first period. When it is close to one, utility derived from a unit of
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consumption in period 2 is almost equal to the utility derived from a unit in period one, and
therefore the degree of impatience is low. In contrary, when it is close to zero, the utility
derived from C1 has more weight, which implies that the consumer is more impatient.
After defining the intertemporal consumer’s budget constraint and utility, we can consider the
decision about how much to consume. The consumer would like to end up with the best
possible combination of consumption in the two periods—that is, on the highest possible level
of utility. To do that the consumer must choose the two levels of consumption that maximizes
his utility subject to the intertemporal budget constraint,
maxU (C , C 1 2 )  ln C1    ln C 2 
c1 ,c2
st. (5)
C2 Y2
C1   Y1 
(1  r ) (1  r )
In general, introductory macroeconomics text books discuss the optimal condition of this
problem using figures like the following:
Figure 1 here
Figure 1 shows that the optimal allocation of consumption (C1, C2) is where the intertemporal
budget line touches the highest indifference curve.
In more advanced undergraduate macroeconomics courses, students also learn to solve this
problem using some analytical tools like the Lagrange function:
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 C2 Y2 
LC1 , C 2 ,    log C1    log C 2    C1   Y1 
(1  r ) 
(6)
 (1  r )
Where the first order conditions for a maximum are:
L 1
    0, (7)
C1 C1
L  
   0, (8)
C 2 C 2 1  r ) 
L C2 Y2
 C1   Y1   0. (9)
 (1  r ) (1  r )
Finally, using conditions (7)-(9), the optimal Euler condition can be obtained
C2
 (1  r ). (10)
C1
The Euler condition (10) shows that the consumer chooses consumption in the two periods so
that the marginal rate of substitution (or the slope of the indifference curve in the previous
figure) equals the marginal rate of substitution plus the real interest rate (the slope of the
budget line in the same figure).
OPTIMIZATION WITH EXCEL-SOLVER
With the help of the Excel-Solver we can introduce a complementary classroom exercise that
solves (5) for the best combination of consumption in the two periods that the consumer can
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afford. We implement the Generalized Reduced Gradient Nonlinear Optimization Method
(GRG Nonlinear).
The Block 1 in Figure 2 sets up the optimization problem of the representative consumer.
Rows 4 to 7 in column B include standard parameter values. The rate of time preference, β, is
0.85; the interest rate is 0.25; the income Y1 is 1000 and Y2 is 2000. To make the analysis
simple, we assume that all variables are real. That is, they are adjusted for inflation. We
introduce the initial values to the present and future consumption in rows 10 to 11 of column
B (we set them at 500 units but this can be somewhat arbitrary). The utility function is
introduced in Cell B23 while the intertemporal budget constraint and the value of saving are
included in rows 14 and 17 of column B, respectively.
Now we are ready to use the Solver. Choose Solver from the Data menu in Excel 20101. The
Solver Parameters window will open. Set the Objective Cell B23 to the location of the
objective function value which is the utility function in our case, select Max, and set the
Changing Variable Cells B10 and B11 to the locations of the decision variables C1 and C2 in
Block 1. Now we need to introduce the constraint (3). Go to the Subject to Constraints box
and select Add. The Add Constraint window will appear. In this window, we tell the solver
that cell B14 must be equal to 0. Then select OK since there are no more constraints to add.
You will return to the Solver Parameters window as shown in Figure 2. Finally, introduce the
value for saving in Cell B17.
Figure 2 here
At this point, we have defined all the necessary components to solve the model. In the Solver
Parameters window click Solve. A window will appear telling us that Solver has found a
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solution. Select Keep Solver Solution and click OK. We just solved the consumer
optimization problem as shown in Figure 3.
As you can see, the consumer has maximized his utility by consuming 1405 units when he is
young and 1493 units during his old age. Since his income is lower than his consumption
during the first period, the consumer borrows 405 units. Also notice that the value of the cell
B14 is equal to zero, implying that the consumer satisfies the intertemporal budget constraint.
Figure 3 here
Next, we can perform some comparative static analysis by modifying the parameters of the
model. To do it, we only need to modify the value of the parameter in the corresponding cell,
in this case B7, and call the solver again. Comparing Figures 3 and 4 we can see how the
increase in interest rate from 25% to 50% reduces the consumption in the first period from
1405 units to 1261, while the consumption in the second period is increased from 1493 to
1608. Since the consumer is a borrower and borrowing money becomes more expensive, the
consumer reduces it, which in turn reduces C1. As a result, the level of utility falls from 13.46
to 13.415 units because the consumer is less inclined to defer consumption to his old age.
Figure 4 here
As a home exercise, we could ask the students to set an example where the consumer is
initially saving money, and analyze the implications of an increase in the interest rate in this
case.
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Until know we have assumed that the consumer can borrow as well as save. The ability to
borrow allows current consumption to exceed current income. When the consumer borrows,
he consumes some of his future income today. Yet for many people such borrowing is
impossible. For example, an unemployed person wishing to buy a car would probably be
unable to finance this consumption with a bank loan. Let’s solve the model under a situation
where the consumer cannot borrow. The inability to borrow prevents current consumption
from exceeding current income. A constraint on borrowing can therefore be expressed as
S  Y1  C1  0
This inequality states that consumption for the consumer must be less than or equal to his
income (period one). This additional constraint on the consumer is called a borrowing
constraint or, sometimes, a liquidity constraint. We next introduce this constraint into the
optimization problem (5),
maxU (C , C 1 2 )  ln C1    ln C 2 
c1 ,c2
st.
(11)
C2 Y2
C1   Y1 
(1  r ) (1  r )
S  Y1  C1  0
In excel, we introduce this new restriction in the cell B17 of Block 1. Then, in the Solver
Parameters window we add this constraint. Click on the Subject to Constraints box and select
Add. The Add Constraint window will appear. In this window, we tell the solver that cell B17
must be higher than or equal to 0 and select OK (there are no more constraints to add). You
will return to the Solver Parameters as it appears in Figure 5. In the Solver Parameters
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window click Solve. A window will appear telling us that Solver has found a solution. Select
Keep Solver Solution and click OK. We solved the consumer optimization problem under a
borrowing constraint as shown in Figure 6. Since the borrowing constraint is binding in this
case, first-period consumption equals first-period income. The level of utility is reduced from
13.415 to 13.369 units because the consumer would like to borrow to consume more in the
first period (as Figure 4 shows) but he is not able to do it.
Figure 5 here
Figure 6 here
CONCLUSIONS
The accessibility and flexibility of Excel spreadsheets gives economics instructors a great tool
to complement the traditional analysis of economics problems. With this tool, applications
that avoid tedious and long calculations can be easily designed to enhance meaningful
learning. In this paper we have shown how to solve the basic two-period consumer choice
model using a spreadsheet and the Excel Solver. We have illustrated the problem using an
example taken from the Mankiw macroeconomics textbook. While practicing the proposed
exercise, the students can explore the main features of the model; and they can learn the key
concepts in a more dynamic and interactive way.
NOTES
1. If the command Solver does not appears in the Data, you can load the instructions that
appear in the following link: http://office.microsoft.com/en-us/excel-help/load-the-
solver-add-in-HP001127725.aspx
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REFERENCES
Abel, A., Bernanke, B. and Croushore, D 2010. Macroeconomics. Pearson Education,
Seventh Edition.
Burda, M. and Wyplosz, C. 2009. Macroeconomics A European Text. Oxford University
Press, Fifth Edition.
Gilbert, J. and Oladi, R. 2011. Excel Models for International Trade Theory and Policy: An
Online Resource. The Journal of Economic Education 42 (1): 95.
Holger S. 2004. Solving Rational Expectations Models Using Excel. Journal of Economic
Education 35(3): 269-283.
Houston, J. 1997. Economic Optimisation using Excel's Solver: a macroeconomic application
and some comments regarding its limitations. Computers in Higher Education Economics
Review 11 (1), 2-5.
Mankiw, G. 2011. Principles of Macroeconomics. South-Western College Pub, Sixth Edition
MacDonald, Z. 1996. Economic optimisation: an Excel alternative to Estelle et.al's. GAMS
approach. Computers in Higher Education Economics Review 10 (3), 2-5.
Mixon, J.W. and Tohamy, S. M. 1999. The Heckscher-Ohlin model with variable input
coefficients in spreadsheets. Computers in Higher Education Economics Review 13(2): 4-
6.
Nævdal, E. 2003. Solving Continuous-Time Optimal-Control Problems with a Spreadsheet.
The Journal of Economic Education 34 (2), 99-122.
12
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FIGURES
1. Figure 1
Second-period
Consumption
C2
Indiference curves (IC)
C2
Y2
Intertemporal budget constraint
C1 Y1 First-period
Consumption
C1
2. Figure 2
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3. Figure 3
4. Figure 4
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5. Figure 5
6. Figure 6
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Solving the two-period consumer choice model with

Keywords Intertemporal Consumer Choice Model, Excel-Solver, borrowing constraint.

JEL codes A22, D91, C65

presence of personal computers both in domestic and professional environments, as well as

personal computers in undergraduate Economics. In particular, Microsoft’s Excel Solver has

using the Excel-Solver.

analyze how rational, forward-looking consumers make intertemporal choices. According to

borrowing constrain into the Solver’s problem to analyze its implications.

THE TWO-PERIOD MODEL

for borrowing is the same as the interest rate for saving.

budget constraint is obtained

value of the income earned.

by the following equation,

U (C1 , C2 )  ln C1    ln C2 , (4)

his utility subject to the intertemporal budget constraint,

problem using figures like the following:

budget line touches the highest indifference curve.

problem using some analytical tools like the Lagrange function:

Where the first order conditions for a maximum are:

budget line in the same figure).

OPTIMIZATION WITH EXCEL-SOLVER

included in rows 14 and 17 of column B, respectively.

value for saving in Cell B17.

optimization problem as shown in Figure 3.

from exceeding current income. A constraint on borrowing can therefore be expressed as

optimization problem (5),

first period (as Figure 4 shows) but he is not able to do it.

concepts in a more dynamic and interactive way.

Abel, A., Bernanke, B. and Croushore, D 2010. Macroeconomics. Pearson Education,

Burda, M. and Wyplosz, C. 2009. Macroeconomics A European Text. Oxford University

Press, Fifth Edition.

Online Resource. The Journal of Economic Education 42 (1): 95.

Education 35(3): 269-283.

Houston, J. 1997. Economic Optimisation using Excel's Solver: a macroeconomic application

Review 11 (1), 2-5.

Mankiw, G. 2011. Principles of Macroeconomics. South-Western College Pub, Sixth Edition

MacDonald, Z. 1996. Economic optimisation: an Excel alternative to Estelle et.al's. GAMS

approach. Computers in Higher Education Economics Review 10 (3), 2-5.

coefficients in spreadsheets. Computers in Higher Education Economics Review 13(2): 4-

Nævdal, E. 2003. Solving Continuous-Time Optimal-Control Problems with a Spreadsheet.

The Journal of Economic Education 34 (2), 99-122.

Indiference curves (IC)

Intertemporal budget constraint

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