Direct foreign investment is incorporated in a dynamic general equilibrium model with endogenous technological change. In contrast to recent endogenous growth approaches, I allow for geographical separation of the innovation and production of newly developed goods. Firms acquire specific knowledge through R&D investment in the more developed country and use their specific asset to establish a production plant in the low-cost country. Foreign direct investment is accompanied by interregional spillovers of knowledge from the more to the less advanced country. I derive a steady-state equilibrium with active innovation and production activities in the high-technology sector in both countries. Furthermore, the implications of factor flow liberalization as well as of industrial policies are investigated.
