DEFINITION of 'Linked Exchange Rate System'

A linked exchange rate system is a method of managing a nation's currency that links it to another currency at a specified exchange rate. While linked to one currency, the managed currency is allowed to float against other currencies. If the exchange rate begins to shift too much from the fixed ratio, currency is added to or removed from circulation by the central bank to bring the ratio back into the acceptable range. The currency being managed may be issued only when there are reserves in the linked currency to back it up.

BREAKING DOWN 'Linked Exchange Rate System'

The advantage of a linked exchange rate system is that it stabilizes the currency and keeps inflation low. On the downside, the nation using it can't use currency depreciation to its advantage in trading with foreign partners, and can't implement monetary policy to adapt to shifts in the domestic economy.

Often countries that use a linked exchange rate system specify a trading range around the selected exchange rate. This band around the fixed rate, which is often plus or minus 1%, adds some flexibility to the regime. Some countries have also employed a "crawling peg" system. This system allows for an adjustment of the fixed rate to compensate for differences in certain economic factors between the managed currency country and the country of the linked currency.

Linked exchange rate systems have been beneficial to some countries. The Hong Kong dollar has been linked to the U.S. dollar for more than 30 years. During this time, Hong Kong has developed into an international financial center, and its assets in its banking system have grown by 13 times. Its gross domestic product also has multiplied nearly 10 times.

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