How the Federal Reserve Finances Government Spending

The United States government spent seven trillion dollars in fiscal year 2025. It collected five trillion in revenue. The difference is the deficit, which was roughly two trillion dollars. This gap gets filled through borrowing, not through the Federal Reserve printing money and handing it to Congress. The mechanics are more indirect than that, and understanding how they work clarifies what the central bank actually does.

Congress decides how much to spend. The Treasury Department manages the actual cash flow. When spending exceeds tax revenue, the Treasury needs to borrow. It does this by issuing securities in the form of bills, notes, and bonds. These are IOUs with different maturity dates. A Treasury bill matures in one year or less. Notes mature between two and ten years. Bonds stretch out to thirty years.

The Treasury holds roughly three hundred auctions per year. It announces the size and type of security days in advance. Banks, hedge funds, insurance companies, foreign governments, and individual investors submit bids. Some bid competitively, stating the price they will pay. Others bid noncompetitively, agreeing to accept whatever rate the auction determines. The Treasury accepts bids starting at the highest price until the full amount is sold.

When the auction closes, the buyers transfer cash to the Treasury. The Treasury deposits this cash in its account at the Federal Reserve, called the Treasury General Account. From there, it pays federal employees, contractors, Social Security recipients, and everything else the government funds. The borrowed money flows directly into the economy through these payments.

The Federal Reserve does not participate in Treasury auctions. By law, it cannot buy securities directly from the Treasury. This restriction forces the government to borrow from the market at market rates. If the Fed could buy directly, the government could bypass price discovery and effectively print money to finance spending without limit.

The buyers at Treasury auctions become creditors to the government. They hold securities that pay interest at regular intervals and return principal at maturity. These securities trade in a secondary market where their prices fluctuate based on supply, demand, and interest rate expectations. When prices fall, yields rise. When prices rise, yields fall.

This secondary market is where the Federal Reserve operates. The Fed buys and sells Treasury securities on the open market, not at auction. When the Fed wants to increase the money supply, it purchases securities from banks and other institutions. When it wants to reduce the money supply, it sells securities.

The mechanism works like this. A bank holds ten million dollars in Treasury securities. The Federal Reserve offers to buy those securities. The bank agrees. The Fed credits the bank's reserve account at the Federal Reserve with ten million dollars. The bank transfers ownership of the securities to the Fed. The transaction is complete.

Here is what just happened. The Federal Reserve created ten million dollars out of nothing and added it to the bank's reserve account. The bank now has ten million in reserves it can lend or use to meet withdrawal demands. The Fed's balance sheet expanded by ten million dollars. On the asset side, it now owns the securities. On the liability side, it owes the bank ten million in reserves.

This is how the central bank creates money. It does not print currency and distribute it. It creates electronic balances in the banking system. Those balances are called reserves, and banks hold them at the Federal Reserve the same way individuals hold checking accounts at commercial banks.

Banks do not need to hold large amounts of cash in vaults. Reserve requirements used to mandate specific ratios, but those requirements dropped to zero percent in 2020. Even without requirements, banks maintain reserves to handle daily transactions, clear payments to other banks, and meet unexpected withdrawals. The size and availability of these reserves affect how much banks are willing to lend.

When the Fed buys securities and increases reserves, banks have more capacity to lend. More lending means more deposits created in the banking system, which expands the overall money supply. When the Fed sells securities and drains reserves, banks have less capacity to lend. Less lending contracts the money supply.

The Fed does not control the money supply directly. It influences it by adjusting the level of reserves and by setting the interest rate it pays on those reserves. Banks can lend their excess reserves to other banks overnight in what is called the federal funds market. The rate charged in this market is the federal funds rate, and it serves as the benchmark for short term interest rates across the economy.

If the Fed wants to lower rates, it buys securities to flood the system with reserves. With more reserves available, banks charge lower rates to lend them. If the Fed wants to raise rates, it sells securities to drain reserves. With fewer reserves available, banks charge higher rates.

The connection between government borrowing and central bank operations is structural but not mechanical. The Treasury borrows to cover deficits. Investors buy the debt. Some of those investors are banks. The Fed later buys some of that debt from banks in the secondary market. This process is not coordinated. The Fed makes decisions about buying or selling based on its mandate to maintain stable prices and maximum employment, not to finance the government.

However, the effect can look similar. When the government runs large deficits and the Fed expands its balance sheet at the same time, the Fed ends up holding a significant portion of outstanding government debt. During the pandemic and its aftermath, the Fed's holdings of Treasury securities increased from roughly two trillion dollars to over five trillion. The balance sheet has since declined but remains around four trillion in Treasuries as of late 2025.

This creates a feedback loop. The government borrows more when it runs deficits. Banks and dealers buy the debt at auction. The Fed buys that debt from them in the secondary market. The banks receive reserves, which they can use to buy more securities at future auctions or to make loans. The cycle reinforces itself as long as the Fed continues expanding its balance sheet.

The reverse also happens. When the Fed reduces its holdings, it sells securities back to banks or lets them mature without replacement. Banks pay for these securities using their reserves, which drains reserves from the system. Fewer reserves mean tighter financial conditions, higher interest rates, and reduced capacity for new lending.

The government does not depend on the Federal Reserve to finance its deficits. The private market absorbs the debt issued at auction. Foreign governments hold roughly eight trillion dollars in Treasury securities. Domestic investors, including mutual funds, pension funds, and insurance companies, hold additional trillions. The Fed holds around four trillion. The majority of government debt sits with entities other than the central bank.

What the Fed provides is liquidity. By buying and selling securities, it ensures that the market for government debt remains functional. During periods of stress, when private buyers retreat, the Fed can step in to prevent disruptions. This happened during the financial crisis in 2008 and again during the pandemic in 2020. The Fed purchased securities at an accelerated pace to stabilize markets and prevent yields from spiking.

Interest on the debt matters. The government paid roughly one trillion dollars in interest during fiscal 2025, making it the third largest federal expenditure after Social Security and Medicare. Higher interest rates mean higher borrowing costs. When the Fed raises rates to combat inflation, it increases the government's future interest burden on newly issued debt. Existing debt with fixed rates remains unaffected, but as securities mature and get refinanced, the government pays the new, higher rates.

The Fed itself pays interest on the reserves it creates. When it buys securities yielding three percent and pays banks five percent on their reserves, the Fed runs at a loss. This happened starting in late 2022 when the Fed raised rates aggressively. The losses do not threaten the Fed's operations because it does not need to maintain capital the way a commercial bank does. Instead, the losses reduce the amount of profit the Fed remits to the Treasury each year.

The system functions because market participants trust that Treasury securities are safe. This trust is based on the government's taxing authority and its history of repayment. If that trust eroded, buyers would demand higher yields to compensate for perceived risk. Higher yields would increase borrowing costs, which would increase deficits further if spending remained constant, creating a reinforcing spiral.

The debt limit adds political complexity but does not change the underlying mechanics. Congress authorizes spending through appropriations. When spending exceeds revenue, the Treasury must borrow. The debt limit caps the total amount of debt the government can issue. When the limit is reached, the Treasury cannot borrow more without congressional action to raise or suspend the limit. This forces either spending cuts, revenue increases, or political negotiation to lift the cap.

The Federal Reserve cannot solve this constraint. It cannot lend directly to the Treasury to bypass the debt limit. It can provide temporary relief by buying securities in the secondary market to ensure liquidity, but this does not create new borrowing capacity for the government. Only Congress can authorize additional debt issuance.

The relationship between the Fed and Treasury is cooperative but legally separate. The Fed operates independently to pursue its mandate. The Treasury manages government finances and borrows as needed. They coordinate on technical matters such as auction schedules and cash management, but the Fed does not take orders from the Treasury or the White House on monetary policy decisions.

This independence matters because it prevents the government from using the central bank to finance spending without market discipline. If the Fed were required to buy all government debt at low rates, inflation would accelerate as newly created money flooded the economy without a corresponding increase in goods and services. Market discipline forces the government to pay competitive rates, which imposes a cost on borrowing and creates at least some constraint on deficit spending.

The constraint is weak when interest rates are low and investors are eager to buy government debt. It tightens when rates rise and demand softens. Auction results can signal stress. A weak auction, where the Treasury must pay higher yields than expected to attract buyers, indicates that investors are becoming more cautious. Repeated weak auctions would force the government to either reduce borrowing or accept significantly higher costs.

The Federal Reserve's balance sheet size influences this dynamic. A larger balance sheet means the Fed holds more government debt, which reduces the amount the private market must absorb. A smaller balance sheet means the private market must hold more. The Fed shrank its balance sheet from nearly nine trillion dollars in 2022 to roughly six and a half trillion by late 2025. This reduction, called quantitative tightening, forced the private market to absorb over two trillion in securities that the Fed no longer held.

Throughout this process, the government continued running deficits near two trillion dollars per year. The private market absorbed both the new issuance and the securities the Fed was selling or allowing to mature. This worked because interest rates rose enough to attract buyers. Higher rates made government debt more attractive relative to other investments, which sustained demand despite the increased supply.

The system operates on a balance between government borrowing needs, private market capacity, and central bank liquidity support. When aligned, deficits get financed smoothly. When misaligned, stress appears in the form of rising yields, weak auctions, or disrupted markets. The Federal Reserve monitors these signals and adjusts its operations to maintain stability, but it does not eliminate the underlying tension between unlimited spending authority and finite market capacity.

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This analysis is for educational purposes. It does not constitute investment advice or a recommendation to buy or sell any security. Investors should conduct their own due diligence and consult financial advisors.