We saw in the preceding chapter that as the government's debt approaches its maximum borrowing capacity, prospective fiscal insolvency can cause the government's creditors to demand high risk premia to hold the government's bonds. Such risk premia would tend to result in high domestic interest rates, depressing aggregate demand and reducing economic activity. When the government's debt increases to the point where it is perceived as having completely exhausted its borrowing capacity, it will be unable to borrow at any interest rate. As we will see in this chapter, such a complete loss of access to credit markets by the government, because it limits the government's fiscal flexibility, has adverse economic effects that are additional to those of high interest rates. In Chapter 25, we will examine the even more destructive effects that arise when, beyond having merely exhausted its borrowing capacity, the government is perceived as having far exceeded it, triggering a sovereign (i.e., government) debt crisis. Given all these negative effects, it is easy to see why avoiding perceived risks of government insolvency – achieving fiscal credibility – would be a high priority for fiscal policy makers in emerging and developing economies.

In the preceding chapter, we began a discussion of how fiscal credibility can be achieved by considering various mechanisms for signaling the government's fiscal intentions to its creditors.