In this paper a two-country general equilibrium extension of the Stockman -Lucas equilibrium exchange rate model is developed. This optimizing framework gives the opportunity to analyse the effect of foreign direct investment on trade and welfare of both the investor and the recipient countries. It is shown that, contrary to conventional wisdom, it is likely that the recipient country will suffer a welfare loss, even though it may improve its trade balance, and despite it having a comparative advantage in production in the sector in which direct foreign investment takes place. Traditional analysts have tended to focus somewhat disproportionately on the effects of foreign direct investment on the trade balance, assuming that an improvement in the trade balance inevitably implied an improvement in welfare. The use of a properly micro-founded two-country model allows this orthodoxy to be challenged.