Q.Explain the classical (real) theory, the loanable funds theory, and the Keynesian liquidity preference theory of interest.

These three theories explain the rate of interest through three progressively wider sets of forces -- purely real, real-plus-monetary, and purely monetary.

Classical (real) theory. The classical economists explained interest through real forces alone, treating money merely as a convenient veil. The supply of capital comes from household saving -- postponing present consumption, an act of "abstinence" that must be rewarded. The demand for capital comes from firms wishing to invest, driven by the expected productivity of capital. Interest is the price that brings saving (supply) and investment (demand) into balance in the capital market.

Loanable funds theory. Neo-classical economists such as Knut Wicksell and Bertil Ohlin widened the classical account by adding monetary factors. The supply of loanable funds comes from savings, dishoarding (releasing previously idle money balances), and fresh bank credit; the demand for loanable funds comes from investment, hoarding (building up idle balances), and government borrowing. The rate of interest settles where the two are equal:

By including bank credit and hoarding/dishoarding alongside real saving and investment, this theory is considered a fuller, monetary account of interest. …

A common error is treating the loanable funds theory and the classical theory as identical -- the loanable funds theory specifically adds bank credit and hoarding/dis …