What is the relation between inflation on a country and the exchange rate of its currency?

Question

In the interval between 2010 and 2011, American inflation was 3.2% and Chinese inflation was 5.55%. During this year, the pair CNY/USD went from 6.2524 to 6.5758. If an investor would have invested 1,000 USD to buy 6252.4 CNY at the beginning of this period, how much would have the investor profited, assuming both currencies are subject to the aforementioned inflation rates? Is the CNY inflation rate already factored in the CNY/USD exchange rate?

Manziel · Answer

Economic theory suggests that as the value of a currency deteriorates, its exchange rate against another currency will reflect this.
However, the devil is in the details

How do you measure inflation?
Typically a consumer price index based on an expected consumption for the "average household" is used. But of course, this is not perfectly representative.
Exchange rates are not only influenced by inflation but by other factors as well such as interest rates, trade balances
Some countries actively manipulate their currency. Switzerland for example has for a long time tried to limit the exchange rate to 1€ >= 1.20 CHF. When this got out of control, the exchange rate dropped to about 1:1. China has been devaluing the Yuan as well

What is the relation between inflation on a country and the exchange rate of its currency?

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