The mechanisms that control proliferation and differentiation of embryonic lung mesenchyme are largely unknown. We describe an explant system in which exogenous recombinant N-Sonic Hedgehog (N-Shh) protein sustains the survival and proliferation of lung mesenchyme in a dose-dependent manner. In addition, Shh upregulates several mesenchymal cell markers, including its target gene Patched (Ptc), intercellular signaling genes Bone Morphogenetic Protein-4 (Bmp4) and Noggin (Nog), and smooth muscle actin and myosin. In explants exposed to N-Shh in the medium, these products are upregulated throughout the mesenchyme, but not in the periphery. This exclusion zone correlates with the presence of an overlying mesothelial layer, which, as in vivo, expresses Fibroblast Growth Factor 9 (Fgf9). Recombinant Fgf9 protein inhibits the differentiation response of the mesenchyme to N-Shh, but does not affect proliferation. We propose a model for how factors made by two epithelial cell populations, the inner endoderm and the outer jacket of mesothelium, coordinately regulate the proliferation and differentiation of the lung mesoderm.