Foreign Investment and Environment in a North-South Model with Cross-border Pollution∗ By

We develop a North-South model with cross-border pollution. In the South, pollution is abated by both private producers and the public sector. The North suffers from cross-border pollution from the South. The policy instruments are the foreign aid for the North, and the fraction of aid allocated to public abatement and emission tax rate for the South. We characterize the Nash optimal level of policy instruments and analyze the effect of foreign investment on environment when the instruments are adjusted optimally. We also look at the case where the North changes both the amount of aid and the level of foreign investment in an income neutral fashion