George Osborne insisted Britain would not "run away" from its problems and vowed to continue with his tough austerity programme after Moody's downgraded the country's AAA credit rating.
In a major blow to George Osborne's economic strategy, the agency reduced Britain's debt rating from AAA to AA1, forecasting "sluggish" growth over the next few years.
Ed Balls, shadow chancellor, said the announcement was a "very, very bad moment" for Mr Osborne after his assertion that losing this status would be a humiliating blow.
The Chancellor has used maintaining the top credit rating for government bonds as one of the key arguments for the Government's austerity programme.
Shadow chancellor Ed Balls called the downgrade "a humiliating blow" to the Prime Minister and Chancellor, who he said "must urgently take action to kick-start our flatlining economy".
"The Chancellor said this would be a humiliating blow and the first test of his policy was to avoid it, so clearly for him politically, it is a very, very bad moment," he told BBC Breakfast.
"I think economically, the credit rating decision itself makes no difference at all.
"What the credit rating agencies are doing though is reflecting the reality and the reality is an economy which is not growing, a deficit which is getting bigger, families in real stress and a government which is ploughing on regardless with a plan which is not working - saying 'the medicine is not working, let's increase the dose of the medicine' that is completely crazy economics."
But Mr Osborne said the loss of the gold-plated status did not mean the government should change course and insisted he will continue with his stark austerity programme.
"We have a stark reminder of the debt problems facing our country - and the clearest possible warning to anyone who thinks we can run away from dealing with those problems," he said.
"Far from weakening our resolve to deliver our economic recovery plan, this decision redoubles it.
"We will go on delivering the plan that has cut the deficit by a quarter, and given us record low interest rates and record numbers of jobs."
Mr Osborne went on: "As the rating agency says, Britain faces huge challenges at home from the debts built up over many, many years, and it is made no easier by the very weak economic situation in Europe.
"Crucially for families and businesses, they say that 'the UK's creditworthiness remains extremely high' thanks in part to a 'strong track record of fiscal consolidation' and our 'political will'.
"They also make it absolutely clear that they could downgrade the UK's credit rating further in the event of 'reduced political commitment to fiscal consolidation'.
"We are not going to run away from our problems, we are going to overcome them."
Chief Secretary to the Treasury Danny Alexander, speaking on BBC Breakfast, echoed Mr Osborne's determination to stick by the coalition plan for economic recovery.
"Of course this is disappointing news, but I have always said that the credit rating agencies are not the be all and end all, what in the end matters is the confidence that people who invest in this country have," he said.
"We still command very low interest rates, historically low interest rates, this country has reduced its deficit by a quarter over the past two and a half years, over a million jobs have been created in the private sector.
"Of course this is disappointing news, but I think in a sense it is a reminder of the difficult challenges that we face as a country and should reinforce our will to deliver the very difficult choices that we promised when we started out in Government."
However, Labour has insisted that withdrawing demand from the economy has put it more at risk by stunting growth.
The statement from Moody's highlights the problems the weak medium-term economic outlook poses for deficit reduction plans.
It now expects the "period of sluggish growth" to "extend into the second half of the decade".
"The main driver underpinning Moody's decision to downgrade the UK's government bond rating to AA1 is the increasing clarity that, despite considerable structural economic strengths, the UK's economic growth will remain sluggish over the next few years due to the anticipated slow growth of the global economy and the drag on the UK economy from the ongoing domestic public- and private-sector deleveraging process," the agency said.
"Moody's says that the country's current economic recovery has already proven to be significantly slower - and believes that it will likely remain so - compared with the recovery observed after previous recessions, such as those of the 1970s, early 1980s and early 1990s."
Mr Balls said Osborne is running out of credibility and said: "The issue is no longer whether this Chancellor can admit his mistakes but whether the Prime Minister can now see that, with UK economic policy so badly downgraded in every sense, things have got to change.
"In the Budget the government must urgently take action to kick-start our flatlining economy and realise that we need growth to get the deficit down.
"If David Cameron and George Osborne fail to do so and put political pride above the national economic interest we face more long-term damage and pain for businesses and families."
Mark Littlewood, director general of the Institute of Economic Affairs, said: "The damaging impact of ballooning national debt, public spending raging out of control and tax rises should not be underestimated.
"Taking immediate action to tackle the deficit must now be the priority. George Osborne should focus on making sufficient savings in public spending to implement a substantial programme of tax reductions.
"With the size and scope of the state in Britain at current levels, it is no wonder our economy is so fragile. The stranglehold of regulation is hurting business prospects on almost every front. In the lead-up to the Budget, Osborne would be wise to respond by taking urgent action."