Financing U.S. government budget deficits, and their impact on interest rates I have two questions. The first is about how exactly the U.S. government finances a budget deficit. The second is about the effects of budget deficits on financial markets and interest rates.


Q1. We say that deficits are financed by the sale of government bonds. But I don't understand exactly what this means. Government bonds are always available for purchase, regardless of whether Congress passes a balanced budget in a particular fiscal year -- right? So it is not that the government issues bonds only in years that run a deficit. So what exactly do we mean when we say deficits are financed by the sale of government bonds? A priori, I could make several guesses. It could mean that if Congress passes a budget deficit in a certain fiscal year, the Treasury issues more attractive securities that fiscal year -- e.g. with higher interest rates -- to incentivize more bond sales that year. (This doesn't seem like it could be true for all Treasury securities, because, e.g. I-bond fixed rates have been virtually zero in recent years despite the huge deficits the last eight years.) Alternatively, it could simply mean that funds accrued from the sale of bonds in earlier fiscal years, stored in some Treasury account, are withdrawn to cover the deficit. I know these are naive questions, and I suspect both are too simple to tell the whole truth, if there's any truth to them. But I'd like to have a better idea of what exactly we mean when we say deficits are financed by the sale of bonds, partly because the answer to this question could matter for the second question.
Q2. In macro 101 we are taught the following toy model. The bond sales used to finance a budget deficit crowd out private investment, since funds spent on government bonds are no longer available for loan to private institutions. This reduction in the supply of loanable funds, in turn, is supposed to drive up interest rates, as financial institutions try to incentivize more investment. But we haven't seen an increase in interest rates in the U.S. despite big deficits over the last several years. Why? What does the toy model get wrong? Is the point that the upward pressure on interest rates predicted by the toy theory can be mitigated by low Fed rates?


If it's easier to point me to an intermediate reference on this material rather than provide an answer, please do so. I'm looking for much more detail than can be found in mainstream elementary macroeconomics books (e.g. Mankiw).
The treasury can issue more bonds and the central bank buys it up, prints more currency and gives it to the government. This is called monetizing the deficit. 
Although this practice may be challenged by the central bank itself depending upon the situation.
The treasury can sell new bonds to commercial banks and other financial institutions. Commercial banks use these to be kept as statutory reserve requirements with the central bank and also as safe assets because these are, of course, most highly rated securities. The demand could be more or less but there is always a demand for safe assets. Think of a countries like China and Japan which invest heavily in U.S treasury bonds and other assets. Theoretically speaking, government can finance any amount of deficits via the central bank route. 

Crowding out will happen when the government is borrowing huge loans from the commercial banks and dries up the sources of funds for the private investors. It also depends on the purpose and timing of the spending. Whether the government is spending on non-productive programs or productive programs which are in turn helping the overall health and investment environment of the nation and whether it is spending counter-cyclically or cyclically. Also, if there is an upward pressure on the interest rates due to possible crowding out, we can expect central bank to make necessary adjustments. 
Moreover, the mechanism is not so simple. It is complex as hell. The flow of savings in the economy is not fixed and hence the pressure may or may not build up. It largely depends on the investor sentiments and expectations also.