Abstract
This paper aims to shed some light on the determinants of Foreign Direct Investment and how the formation of multinational firms affects the global economy in terms of economic growth and production patterns. To do this a dynamic general equilibrium model of North-South trade with increasing variety and scale-invariant growth is developed. Northern firms do costly R&D to expand the number of available consumer good varieties, while also devoting resources to adapt the production process to southern conditions and thereby benefit from lower costs of production. Endogenous rates of innovation and adaptation are determined as well as the wage differential experienced by Northern and Southern workers. Policies supporting the international integration of product markets are shown to temporarily increase the rate of innovation and permanently increase the rate of adaptation. Whereas a less developed country's decision to adopt a free trade policy and open up for FDI has no effect on the North-South wage gap in this case, the southern adoption of a FDI-friendly policy serves to reduce this wage-gap.