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simply mean that funds accrued from the sale of bonds in earlier fiscal years, stored in some Treasury account, are withdrawn to cover the deficit.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).