Cities serve as critical carriers for driving high-quality development, creating high-quality life, and comprehensively building the socialist modernized country. Exploring the mechanisms and actual effects of foreign direct investment (FDI) on urban shrinkage holds significant implications for urban development in the Yangtze River Economic Belt. After preprocessing DMSP/OLS and NPP/VIIRS nighttime lighting data, this study adopts an intercept-free “S-shaped” model to fit the integrated nighttime lighting time-series data of 105 prefectural-level cities in the Yangtze River Economic Belt from 2005 to 2019. Urban shrinkage is measured through the extraction of shrinking pixels. This study primarily adopts a spatial spillover perspective to empirically test the impact of FDI on urban shrinkage using the spatial Durbin model (SDM), followed by robustness checks, heterogeneity discussions, and the construction of a non-linear model to explore the mechanism of FDI on urban shrinkage through the pathways of labor income and environmental quality. The study has found that: 1) There is an inverted U-shaped relationship between FDI and urban shrinkage and the model exhibits significant spatial spillover effect, primarily driven by knowledge spillover effect and competitive imitation effect. The spatial spillovers even surpass direct effects. 2) In both eastern and western regions, FDI shows a significant inverted U-shaped relationship with urban shrinkage, whereas the relationship is insignificant in central regions. While the three regions (eastern, central, and western) possess unique strengths, resource mobility across regions remains limited. 3) The effect of FDI on urban shrinkage is significant in non-resource-based cities but negligible in resource-based cities. 4) FDI affects urban shrinkage through the employment absorption effect and the environmental pollution effect. Based on these findings, the study puts forward the following policy recommendations: 1) Pay attention to the essence of urban shrinkage and reframe traditional misconceptions. Advocate for a smart shrinkage approach that adjusts urban scale and functional layout, while maintaining fundamental vitality. 2) In light of the regional heterogeneity of the Yangtze River Economic Belt, implement differentiated foreign investment introduction strategies. The eastern region should further optimize its foreign investment attraction policy and promote the introduction of high-tech and high-value-added industries. In contrast, the western and central regions should prioritize foreign investment on local industrial upgrading and employment absorption, while mitigating environmental pollution and resource competition risks associated with excessive reliance on foreign investment. 3) Establish a coordinated development mechanism to promote the synergistic development of opening-up platforms, and promote the synergistic orientation of domestic and foreign investment and urban development goals in the Yangtze River Economic Belt. The study offers valuable insights into addressing the problem of smart shrinkage in the Yangtze River Economic Belt to build an inclusive, resilient and adaptable urban development model.