Net foreign assets, productivity and real exchange rates in constrained economies

► We develop a two-sector model where the economy faces a constraint on capital inflows. ► Real exchange rate (RER) determinants depend on the country's ability to borrow from foreigners. ► In a constrained steady state, the RER depends on both net foreign assets and productivity. ► In an unconstrained economy, the RER depends only on productivity. ► Econometric estimates of the long-run RER behavior support theory predictions.