Higher domestic income leads to a higher domestic demand for all goods, both domestic and foreign. So a higher domestic income leads to higher imports.
The more expensive domestic goods are relative to foreign goods—equivalently, the cheaper foreign goods are relative to domestic goods—the higher is the domestic demand for foreign goods. So a higher real exchange rate leads to higher imports.
Movements in the real exchange rate were reflected in parallel movements in net exports. The appreciation was associated with a large increase in the trade deficit, and the later depreciation was associated with a large decrease in the trade balance.
There were, however, substantial lags in the response of the trade balance to changes in the real exchange rate. Note how from 1981 to 1983, the trade deficit remained small while the dollar was appreciating
real exchange rate is the relative price of domestic goods in terms of foreign goods. It is equal to the nominal exchange rate times the domestic price level divided by the foreign price level.
The experience of the United States in the 1990s shows that real exchange rate appreciations lead to trade deficits and real exchange rate depreciations lead to trade surpluses.
Demand for domestic goods refers to the total demand for the goods produced within a country's boundary by domestic producers. This demand is the sum of the goods demanded by the people within and outside the country. It is given by Z = C+I+G+(X-M)
