The Silao, Guanajuato plant in central Mexico is expected to build 330,000 engines annually from 2013 to meet demand from its Chattanooga, Tennessee, and Puebla, Mexico plants.
Currently, the Volkswagen Jetta, Golf Estate and the New Beetle are produced in Puebla. Production of the company's new mid-size sedan is scheduled to begin in Chattanooga in 2011, the company said.
Mexico plays a key role in the company's attempt to recapture North American market share, Otto Lindner, executive president of Volkswagen Mexico, said at a press conference.
Volkswagen plans to sell 1 million vehicles in the U.S. annually by 2018, three times its current rate.
Volkswagen's best-performing year in the United States was 1970, when it sold 569,696 vehicles there and had nearly 6 percent share of the U.S. market, said a company spokeswoman.
Today, Volkswagen and Audi -- the company's two major U.S. brands -- comprise about 3.2 percent of U.S. light vehicle sales.
Silao is the site of a General Motors Co GM.UL pick-up truck and sport-utility assembly plant. The existing base of auto parts suppliers played a role in Volkswagen's choice of the city. the company said.
The world's No. 3 automaker behind Toyota Motor Corp and General Motors will employ about 700 workers at the plant. The number of jobs at suppliers in the area are also expected to rise.
Lindner said the Guanajuato plant will be bigger than the engine factories the company currently operates in the United States and other areas outside Europe.
Mexican President Felipe Calderon, who joined Lindner at a press conference, said Mexico remained competitive for international automakers.
With low production costs in factories, with a strategic geographic position that permits direct and quick access to the markets of the United States and Canada, Mexico offers unequalled conditions for auto production, said Calderon.
Some foreign-owned factories in sectors ranging from electronics to medical supplies have frozen investment in Mexico, worried about escalating violence as drug cartels wage what Calderon called a war with the government.
More than 29,000 people have died in drug-related violence in Mexico since Calderon began a military offensive against drug traffickers in late 2006, according to government and media tallies.
Mexico is also home to assembly plants run by foreign automakers, like Japan's Nissan Motor Co Ltd.
Auto manufacturing is at the heart of Mexico's export economy, which sends roughly 80 percent of finished goods to the United States.
(Additional reporting by Bernie Woodall in Detroit and Cyntia Barrera Diaz in Mexico City, editing by Leslie Gevirtz)