Loanable Funds Theory
Loanable Funds theory makes an improvement on the classical theory. Money can play a decisive role in saving and investment. In turn, the saving and investment determine the income level. According to this theory, rate of interest is the price that equates the demand and supply of loanable funds.
Loanable funds are defined as ‘the sums of money supplied and demanded at any time in the money market’. Classical theory talked about money supplied as a result of savings of the people. This theory takes into account money resulting from savings of the people and money resulting from credit creation of the banks. Thus, Loanable Funds Theory redefines the supply side.
Demand side is also redefined by this theory. Demand for money comprises demand for investment (as per classical theory) and the demand arising from need to hoard the money. Money borrowed may not be invested immediately. It may be hoarded and invested in the near future at an opportune moment for investment. Classical Theory held the rate of interest as a determinant of saving and investment. Loanable Funds Theory holds that savings, investment, credit creation in the economy and the demand for money arising out of a need to hoard the money determines interest.

Liquidity Preference Theory
J.M.Keynes propounded this theory. He held that interest is a purely monetary phenomenon in that the rate of interest is determined by demand and supply of money. Interest is considered to be the reward for making the people to part with liquid money i.e., cash. People prefer to hold their wealth in the form of cash rather than in the forms of assets like bonds and securities. Demand for money arises due to demand to hold cash. Demand to hold cash arises due to the role of money as a medium of exchange and as a store of value. It is used as a medium of exchange for transaction motive and as a precautionary motive. Store of value arises due to speculative motive. The demand for money is the total of money needed for all these there motives.
The liquidity preference schedule expresses the functional relation between the quality of money demanded for all these motives and the rate of interest. As per the Liquidity Preference Theory, the equilibrium rate of interest is decided by the interaction between liquidity preference function and the supply of money. Any change in the liquidity preference alters the demand for money and thus causes a change in the interest rate. In the same way, any change in money supply also has its effect on the interest rate.
Prof. Hansen criticizes Keynes’ Theory on the same ground on which Keynes criticized Classical Theory. The liquidity preference function depends upon level of income. To know the level of income, we should know the rate of interest.