A functional assay to clone mouse mesoderm inducers has identified the mouse gene Mad related 2 (Madr2). Madr2 induces dorsal mesoderm from Xenopus ectoderm and can mimic the organizer in recruiting neighboring cells into a second axis. By analyzing the expression of a lacZ/Madr2 fusion protein, we find Madr2 confined to the nucleus in the deep, anterior cells of the second axis, whereas in epidermal and more posterior cells the protein is cytoplasmically localized. This context-dependent nuclear localization suggests that in certain regions of the embryo, Madr2 responds to a localized signal and amplifies this signal to form the second axis. Furthermore, although Madr2 remains unlocalized in ectodermal explants, addition of activin enhances the concentration of Madr2 in the nucleus. Significantly, a functional lacZ fusion to a carboxy-terminal portion of Madr2 is nuclear localized even in the absence of activin. This indicates that Madr2 contains a domain that can activate downstream components and a repressive domain that anchors the protein in the cytoplasm. Nuclear localization of Madr2 in response to activin, and the activin-like phenotypes induced by overexpression of Madr2, indicate that Madr2 is a signal transduction component that mediates the activity of activin.