Link exchange and reciprocal linking
Link exchange and illicit linking
Yes link exchange and reciprocal linking (you link to me and I link to you, same thing) is allowed in Google, but only to a certain degree of not been excessive.
Google first said avoid reciprocal links. Then they added the word "excessive". Which by itself doesn't say very much. Each Webmaster treating the word excessive differently.
So then what are excessive reciprocal links?
Matt Cutts spoke about fundamental long term, solid growth of your links, saying you need to avoid getting links if a large fraction of them are coming from you sending automated emails saying: "Did you know that exchanging links can help your rankings in search engines?". Or for that matter, advertising reciprocal links on your website.
If that's your sole purpose, you're wasting your time thinking its the basis for fundamental long term growth of those links and all your other links.
The above are against their guidelines and an untrue statement at that. If abused, follow reciprocal links can hurt your websites rankings and even be the course of you receiving the dreaded unnatural link penalty in Webmaster Tools.
Always keeping in mind that ALL links, including reciprocal links need to be relevant to your content and most definitely useful to the visitor.
Reciprocal links are without a doubt part of the web and will at some point occur. But it most definitely doesn't mean you have to go out on a mad crusade chasing down follow reciprocal links, exchanging follow links with irrelevant sites purely to create doorway pages and a higher PageRank.
Ask yourself this question: Would I have exchanged the link if I wasn't worried about search engines?
The majority of Webmasters would say no. So avoid excessive link exchange, specifically if your main intention is PageRank and you needn't focus too much on authority sites. You can gain more from low PR pages if the link is in your niche (If the link from a low PR page is good, do it)
The next thing you need to establish, is the reciprocal link good for users? if so, exchange links.
Most Webmasters are under the impression that other Webmasters won't give a link if one is not returned. That is a load of crap. If the content is useful to the visitor they will automatically link to you. Those are the best reciprocal links, links that come naturally.