A linked exchange rate is used as a system to manage the currency, as well as exchange rate, of a country by linking its prevailing currency to a more stable base currency, which is held in fixed ratios by deposits of the account holders in various local banks.

Negligible State Interference

After the exchange rate is realistically fixed, the government or its monetary policies which may affect the set exchange rate, will normally not exercise any influencing interference. Therefore, foreign currency banknotes will be issued only when the concerned bank has adequate reserves to back up the issue value. Should the exchange rate start changing compared to the fixed ratio, depending on whether there is an increase or a decrease in currency, either additional currency will immediately be added to it or withdrawn from circulation, in order to restore the fixed ratio and return it to a balanced position.

This is quite different from simply pegging any one currency to a more stable currency. In case of a linked exchange rate system, further currency can be issued only when adequate reserves of the linked currency are available with domestic banking institutions. For example, in Hong Kong this would mean that each Hong Kong Dollar which floats in its economy is fully backed by a higher ratio of United States Dollars that are held as a reserve.

A noticeably distinct advantage of such as system ensures that the currency remains in perfect equilibrium, which helps to keep normal inflation rates at extremely low levels. However, on its downside, the country that uses this system will not be able to leverage any advantages when trading with its foreign partners. Further, it will not be able to implement any monetary policies in order to favorably adapt to any possible shifts in its domestic economy.

The international foreign exchange market, also known as forex or simply FX, is the largest single financial market in the world. As of 2009, a staggering daily average of over $3 trillion exchanges hands. Some useful suggestions may help to understand why some exchange rates fluctuate while a number of others remain stable. Basically exchange rates establish the price at which legal tenders of one country can officially be exchanged for those of any other selected country’s prevailing currency.

Floating Rate versus Fixed Rate

Fixed, or pegged, exchange rate establishes the rate fixed by a government, through its central bank, as the officially declared exchange rate. In order to consistently uphold exchange rate of the local currency, the central bank sells and buys its own local currency from the official foreign exchange market at its pegged rate. It must therefore maintain high foreign currency reserves.

Whereas, floating exchange rate draws its importance from the private or open market. Hence, it is strongly influenced by the needs of market demand and supply. Floating rate is frequently also termed as ‘self-correcting’, since any significant changes in the market demand and supply will automatically correct the established rate. For instance, when demands for any specific currency are low, the value will likewise decrease; thus import of goods will be more expensive, which in turn will stimulate the demand for locally produced goods. This will generate additional jobs and bring about auto-correction inside the local market. As such, the floating exchange rate keeps consistently changing.

In practical terms, no currency can either be entirely floating or fixed. In most mixed systems, market pressures play a major role in influencing considerable changes in exchange rates. When some local currency fails to reasonably portray its true current value in comparison to the pegged currency, a more reliable black market will spontaneously sprout.

Fixed exchange or a pegged rate regime is a foreign currency exchange rate system, which is overwhelmingly practiced by most countries, in order to match its official currency exchange rate to the value of a single other country or to a selected basket of a fixed number of other currencies, or often to the prevailing gold price. It is governed by strict laws, enforced by the central banks of respective countries, for the prime purpose of maintaining a fixed value for its currency within a selected narrow band.

As such, other than simply offering greater assurance to importers and exporters, fixed exchange rates help governments to maintain lower inflation rates which on a long term assist in keeping down the interest rates and simultaneously stimulate improvements in investments and trade.

Distinct benefits of pegging

Pegging is a universal system of stabilizing the currency of a country by fixing its respective exchange with that of a more stable country. Hence, many developing economies prefer to peg their own fixed exchange rates with those of the United States, for obvious reasons.

As a means of lucrative business, and with the sole intent of amassing substantial gains, many knowledgeable investors purchase very large amounts of selected underlying commodities or securities off the market at a time period when the said products are closer to their established expiry dates. This encourages a positive move or response in their respective market values.

However, many potential investors, who write ‘put options’, invariably use pegging as a means to ensure that they will not be forced to buy the underlying commodities or securities from such option holders, should the market prices of such products drastically drop. The prime purpose of this procedure is to conveniently render the purchase offer expire as worthless or non-executable, so that any and all initial premium received by the said writer is fully protected.