Historically, a currency was tied to either gold or silver – or both. During WWI flat currencies became the norm, due to mounting costs, and until 1970 most currencies “flirted” with gold one way or another. Nowadays, pretty much all currencies are either floating or fixed, with fixed currencies typically pegged to a stronger nation’s (usually floating) currency.
Why tie currencies to begin with?
Currency is the key asset to influence several part of a nation’s economy. There are many reasons why a country would tie its own currency to another’s are quite diverse. If a large portion of their income came in a foreign currency, say Euros, said country would have a practical reason for pegging its currency to the Euro, or even letting the Euro supplant the native currency altogether (unofficially). Safeguarding against monetary shocks and market fluctuations is also much easier with fixed currencies – they are more stable than floating currencies. The fact is you need stable currencies if you are going to do business on the open market or keep your goods and services competitive. And keeping a stable currency in relation to that of your largest trading partner is a major boon. And pegging currencies is not reserved only for small countries with small economies. Notably, China’s currency, the Yuan, seems to follow the US Dollar even though this pegging is not official. It does, however, help China maintain its export-driven economy on the rise. On the other hand, just maintaining a fixed course can prove a major drain on the foreign reserves of a small country as the central bank in question is forced to trade its own currency on a constant rate to maintain the exchange course while struggling to keep an adequate monetary supply as well. And if anything happens to the “anchor”, the fixed currency also risks a freefall and inflation.
Floating currency has its advantages and disadvantages as well, most of which stem from the nature of the open market. Floating currencies are dubbed ‘self-correcting’ although this term could be a bit misleading. It is the supply and demand that determine the exchange rates, and people (market) control those two. If supply outweighs the demand, the currency in question will lose value, and imported goods become more expensive (and vice versa). If the economy is stable enough on its own, there is little need to adjust currency value unless there is a major shift that threatens the balance.
In truth, this whole division of currencies on fixed and floating is a bit redundant, as no currency is ever truly “fixed”. Their values can and do change eventually. It just happens more often to the floating currencies. As to which is better, it comes down to the individual country and its economic interests. Some countries favor stability and keep the status quo out of necessity while others see no point in using up foreign reserves to retain something they do not find necessary.